Value investing has come a long way since it was created by Benjamin Graham in the early part of the last century.
Graham’s form of value investing was simple compared to today’s various methods. Graham sought out those companies trading at a discount to the net value of their assets, a style made easier by the fact financial information was not widely disseminated and stocks were more akin to chips in a casino when he first started investing.
Today, financial information on stocks is readily available to most investors and there are hundreds of bloggers out there who spend hours trawling through financial filings and reports to find those investments that do not fall into the public eye. As a result, finding traditional value stocks has become almost impossible.
Still, value has evolved over the years. Today, there are three main types value investors tend to look for when trying to uncover neglected stocks.
Three types of value
Market value is probably the most well-known of these three. Market value is simply the value of a company at one point in time determined by its share price. Market value is essentially the company’s market capitalization and differs substantially from other value calculations. Just because a stock trades at a certain price does not mean the company is worth that amount. Indeed, market value is determined more by human emotions than actual business fundamentals, something Benjamin Graham tried to get across in his Mr. Market analogy.
The second type of value is intrinsic value. Often referred to as underlying business value, intrinsic value reflects a company’s worth and is based on a calculation of future cash flows. An investor forgoes capital today to achieve higher returns in the future. While a company's shares can theoretically trade at any price, a company is not worth more than the value of those discounted cash flows. A Warren Buffett (Trades, Portfolio) quote describes the intrinsic value and its benefits perfectly:
"Intrinsic value is the number, that if you were all knowing about the future and you could predict all the cash a business would give you between now and judgement day, discounted at the proper discount rate, that number is what the intrinsic value of the business is. In other words, the only reason for making an investment and laying out money now is to get back more money later on. That's what investing is all about. When you look at a bond it's very easy to tell what you get back, it says it right on the bond, it says when you get the interest payments and the principal. The cashflows are printed on the bond, the cash flows aren't printed on the stock certificate. That's the job of the analyst, to change that stock certificate, to change that into a bond. To say that's what I think it will pay out in the future."
Private value
The third type of value is private market value. This method of valuation differs from market and intrinsic value as it assumes that the business in question is being acquired. Therefore, the acquirer will receive all future cash flows and can determine the capital allocation, cut costs to improve synergies and may receive tax benefits.
As a result of these developments, private market value tends to be higher than intrinsic or market value as the value unlocked from the business over time can be greater. That being said, private market value is harder to calculate than intrinsic value (market value is determined by the markets, so there is little need to calculate). The terminal private market value will depend on the acquirer. A skilled acquirer that has a history of seamlessly integrating businesses will be able to extract more value from the company over the long term, although it may pay less for the business upfront than an unskilled acquirer chasing growth at any cost.
The bottom line
So, which value is the best value for investors to use? Intrinsic value and private market value both have their benefits. One is significantly more difficult to calculate than the other, but ultimately, if the business is worth a dollar and you can buy it for 40 cents, you are on the right track.
“If a business is worth a dollar and I can buy it for 40 cents, something good may happen” -Walter Schloss
Disclosure: The author does not own any share mentioned within this article.
Start a free 7-day trial of Premium Membership to GuruFocus.
