My father bought a new car. Its a Ford Ranger 2015 (actually a pickup) and being the investor in the family I thought that he is (again) throwing money away. I just see no value in owning a car if you already have one. And that is what we are going to talk about today – value.
We are value investors. We should be able to know if something is more valuable than the market is pricing it. Mistakes of people is where we profit. Value is such an abstract concept that its hard to explain. Why do we pick one brand over the other? Why do we buy things, than the other things? Our decision is govern by that question – is this valuable than all the other alternatives? But what exactly is value?
As far as I know, there are 3 kinds of value (when it comes to stocks or businesses obviously since this is a value investing blog.). They are:
- Earnings Power
The lower you go down the list, the harder and the muddier (and more speculative) it gets to evaluating a company. Meaning, Assets are clearly easier to evaluate than Growth.
Let’s start with what Ben Graham taught us. Since everything in the balance sheet in a company may or may not be what they say they are, the only thing that is sure to be somewhat of the same value are the tangible assets. In other words, all the things listed in the balance sheet assets may not actually be what its worth in reality. But one thing is for sure, the tangible assets would be most accurate.
So knowing the value of the tangible assets less all its liabilities and ignoring the other assets in the balance sheet, you can arrive at a certain value. If you subtract just the assets that we are sure of, less all the liabilities and still arrive at a positive number, you just found an undervalued stock. This is what we call the net-nets.
Think the price of the Ford Ranger in the market today.
Earnings power will take us to what Ben Graham left off and what Warren Buffett picked up on. Some companies trade at prices that are above and beyond the value of the tangible assets. Since we can’t use the asset to evaluate the company (because they are so much a premium to its net-net value), the power of the business to earn money is what we use.
Warren Buffett said, to value a company, add all the earnings of a company from the beginning of its life to its end and discount it back to present value. You might notice that he doesn’t care much about the assets that bring those earnings. But definitely, there’s value in something that earns money for you right? Assets have prices on their own, but the power to earn makes it a little muddy to know what the value of.
Think the earnings power of the Ford Ranger for Uber or Grabcar.
Beyond assets and earnings power is growth. Peter Lynch is probably the most popular investor who looks at growth. And this is perhaps the most speculative as we are down the bottom among the 3. And it shows, people who perceive growth or even an optimistic view of growth will pay more for that asset today. People like fast growing companies. Most value investors won’t be looking at growth as the main criteria. Since growth is very hard to value, most of us just try to value the assets and the earnings power. If we could buy something that is cheap, you can forget growth altogether (or think of growth as a bonus if you bought a really cheap company).
Value and growth is joined at the hip. Growth is actually a component of value if you look at it.
Growth certainly adds to the value equation, but its hard to put a finger on it. We don’t know what the future holds and we don’t know when a growing company will stop growing (and by how much). But one thing is for sure, if you know the business well and the industry well, you might have a chance to know the value of that growth. Be careful investing in companies that all it has is growth. You only need 1 bad earnings report and its enough to crash its high valuation.
Well, cars don’t really have growth. But they have reverse growth (depreciation).
No Value at All
Let’s make it easier. You don’t have to actually know the value for earnings power and growth because very few companies meet the criteria. And here’s the criteria, Earnings Power and Growth only has meaning if there is competitive advantage. If you don’t have a moat for the business, Earnings Power and Growth is useless. So that would shrink the universe of companies you will look at.