Businessman Investor

Touching base with the rational business psyche of stock market investors

Wednesday, September 14, 2011

On Price, Value, Value Investors, and Equity Perpetuity

This is Part 1 of a Series

The following are excerpts from a discourse I had with a fellow investor with regards to future price projection, focusing on business value, and the usefulness/relevance of the equity perpetuity theory. Let me stress that I don’t claim these constitute canon—these are just my own personal views.

Value investors don't project price, they project value. It should always be some underlying value you're anticipating to get. The difference maybe subtle, even trivial, but in my view, crucial and vital.
The whole intent behind the equity perpetuity concept is to find a safe purchase price (for an excellent business) to achieve your required rate of return. The intention is not to project a target sell price or predict the market. The intention, primarily is capital preservation (through sound business/fundamental basis as represented by forecasted flat earnings/cash profits—you can never rely on market swings/movements to preserve capital anyway) and exposure to rational potency of earnings. And that's primarily the focus and intent of value investing.

Indeed, the principle of value investing is purchasing excellent businesses at bargain prices and not to forecast a future stock price or predict what the market will do. And that being the case, value investors are first and foremost, naturally conscious and very focused on not losing money (that's why all the fuzz on buying a bargain price)—that is, capital preservation—but with the added benefit of exposure to rational potency of earnings (i.e. because of buying into a defensive stock position with an underlying profitable business).

Anticipating a future stock price should never be explicit. Because once you start throwing off some stock price projection tool, the focus tends to be just that: market price forecasting. And there's the peril of neglect where value comes in the first place—the underlying business.

The focus should always be the business. The expected return should be based and assessed on some measure of value the business is going to generate or that is inherent in the business. That's why, notice when we try to project a target rate of return using the equity perpetuity approach, the basis is flat earnings/cash profits (which are measures of value). Even the discounted cash flow (DCF) model espouses this philosophy by projecting and discounting cash flows. The focus has never been a future stock price; it has always been some underlying value you're anticipating to get. The difference maybe subtle, even trivial, but it has a lot of bearing on understanding that underlying businesses are the very essence and source of value—not the market—and that's where capital preservation and earnings potential come from.

Value investors base and evaluate their return on what value the business can fundamentally and realistically achieve (and this is explicit in my perpetuity approach or other DCF approaches). Or to put it bluntly: Value investors don't project price, they project value—and projected value is the basis of how they assess a purchase price in achieving their target rate of return. Computing a future price value doesn't tell you at what price to buy (and consequently whether a stock is underpriced). It just tells you what the future stock price will be.

Value investors will never confess and be explicit that they can predict a future stock price. More so, they are also not implicit in forecasting a stock price because they do not intend to chart price movements—they are implicit and explicit, however, of predicting/forecasting business value, because they are conscious and mindful instead of business value. Market price and business value are two different things. Price is what you pay, value is what you get. Continue to Part 2: On Realizing Gains, Compounding Value, and Equity Perpetuity

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The information presented here is for educational purposes only. Under no circumstances should it be construed as a recommendation to buy, sell, or hold any stocks. If you choose to use this information, you do so at your own risk.

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