The Greater Fool Theory is a belief that you can buy a stock at any price and sell it to some other, bigger fool for a profit. In times of ever-increasing markets, this theory often shows itself to be true. Still, reality must come crashing down at some point. It always does. And that is precisely when great fools lose tons of money, and great investors come to life.
There is definitely no shortage of fools in the market. In their ongoing quest for short-term profits, fools will, with absolute disregard for value, drive prices up and down wildly. And they will invariably screw up-to the ultimate profit of smart business investors.
Let’s take some investing advice from Warren Buffett, and use it to determine how to value a business.
Understanding Market Mania
The key to investment success is to identify which companies will rise in price-faster and longer than the others. Over the long term, the price of an investment follows its value. To know whether or not an investment’s price will rise in the coming years, you need to purchase that investment at a discount to its value and then hope that value will rise.
Buffett says,
In the short run, the market is a voting machine but in the long run it is a weighing machine.
On a day-to-day basis, the fools will fly bad companies high and drive wonderful companies down-and vice versa. Over time, however, the markets will drive the price of great companies up-and that of bad companies down.
Understanding Value Vs. Price
One of the most misused terms on Wall Street is “value”. Stocks are commonly referred to as “undervalued” or “overvalued” in reference to whether or not they are attractively priced. The reality is such that a stock can never be under- or overvalued-merely under- or overpriced. The value of a company at a given point in time is fixed, the price moves rapidly above or below that value as the fools play with the stock.
As Warren Buffett tells us:
Price is what you pay, value is what you get.
In other words, no matter what price you pay for a stock, you end up with the same amount of value.
Putting Them Together
What is the world’s greatest investor telling us? Simply this-if you buy $1 worth of a growing business, and you spend less than $1 to get it, you will make money in the long term. Is that a guarantee? No-but it is as close as you can get, and certainly more of a sure thing than Wall Street is offering.
What Is The Value Of A Business?
When determining the value of a company-and hence, the price you should pay for its stock-you need to know the company’s intrinsic value-its value as an ongoing business. The intrinsic value is the value of a company’s operations if it had to rely on operations alone to grow and pay its bills. Though at first glance that may seem obvious, it is not always so. Too many companies rely on taking on debt, selling assets, or issuing stock to fuel their growth or sustain operations. These actions all serve to reduce the company’s value.
Mr. Buffett?
The critical investment factor is determining the intrinsic value of a business and paying a fair or bargain price.
Intrinsic value is comprised of two things-the Shareholder Equity of the company today and the discounted value of the cash that can be taken out of the business. Let me put that into Plain English.
Shareholder Equity
Shareholder Equity is a company’s net worth. It is essentially the sum of money investors would be entitled to if the company stopped operations, sold off all of its assets, paid off its debts, and distributed cash to owners.
When you buy a company, you are entitled to your fair share of its net worth if the company closed up shop. A quick way to understand this is to think in terms of a small business. If two business partners decided to close down and go their separate ways, they would each take half of the equipment, signs, etc.
When you buy a stock, you are becoming a partner in the business-along with thousands of other investors. Should your company close down, you would be entitled to your share of the desks, signs, etc.
Why Shareholder Equity Matters
Most investors do not concern themselves with Shareholder Equity because they do no believe that their company will ever go out of business. Maybe they’re right. Still, Shareholder Equity is a base that protects you from years of slow growth, from competitors tapping into your company’s markets, and from a “worst case scenario” of your company closing down or being forced to liquidate.
Shareholder Equity is easily found on any balance sheet of any company. For example, take a look at Berkshire Hathaway’s Shareholder Equity. In 2000, an investor in Berkshire would have been entitled to his or her share of $61.7 billion if the company was liquidated. In 2006, that same investor would have been entitled to share in $108.4 billion if Berkshire closed down.
Moving On
Take a look at Part II of Calculating A Business’ Value-the discounted value of the cash that can be taken out of the business. Don’t worry-technology has made it pretty easy to figure out.
Filed under: How to Value a Business
Sanjay,
Buffett tells us,
Stop trying to predict the direction of the stock market, the economy, interest rates, or elections.
A great business can plow through this storm – a mediocre or bad one may not. Though a business might have a set back because of the Sub-Prime mess, a Democratic house, or high interest rates, great ones will still be great when the dust settles.
What is happening in the markets right now is no better or worse than other crises over the past 100 years. And still, wonderful companies grew.
If you have short-term or speculative positions, now may be the time to review and or dump them and get into truly outstanding companies.
Edit: Check out Buffett’s response to this same question over on CNBC’s Warren Buffett Watch.
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Isn’t shareholder equity a theorectial term? For if a company was forced to liquidate, in some cases, it would have to settle for fire sale prices and not the asset price listed on the balance sheet. And how do you value a company a large goodwill or other intangible assets?
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In a fire sale, book value is the number to look at. In a strategic liquidation, shareholder equity is a better indicator of value. The rationale is simple – if your company purchased a business for $X above that business’ book value, it would carry goodwill on the books. It is also rational to assume, then, that the newly acquired subsidiary could be sold at a premium to its net tangible book value in a liquidation.
But we aren’t generally buying on the assumption that the business will close. Instead, we hope it will operate forever. Still, we can’t ignore the Goodwill and intangibles that can be sold at or above those premiums our company paid.
In his 1983 letter to shareholders, Buffett had this to say about Goodwill:
Thus our first lesson: businesses logically are worth far more than net tangible assets when they can be expected to produce earnings on such assets considerably in excess of market rates of return…What is more likely is that the Goodwill will increase – in current, if not in constant, dollars – because of inflation…That probability exists because true economic Goodwill tends to rise in nominal value proportionally with inflation.
Essentially, goodwill is an asset that should rise in value – one just as important and potentially tangible as the bricks and mortar (and machinery, et al) that make up net tangible book value.
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Hi,
I’m new to this and I love the clear and concise instructions you have given. So yes, I get that shareholder’s equity is an important factor. But how do you determine if Company A is more attractive/safer than Company B by looking at shareholder’s equity? Is it by taking the shareholder’s equity divided by total liabilities equity?
Thanks and rgds. =)
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Joe,
I don’t agree with this calculation.
In Buffett’s 1983 letter to shareholders, he was talking about economic goodwill and not accounting goodwill which would more closely mean moat than the figure stated in the statements, right?
In fact he writes to ignore the goodwill statements and amortization charges in financial statements and look at value from an economic goodwill point of view.
Hope to receive a reply on this.
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Benny, I think he was talking about goodwill in GENERAL as an Intangible asset.
But I understand your confusion, your right.
In Essays from Warren Buffet, it is clearly stated that economic goodwill tends to increase overtime for franchises(nominally with inflation). In contrast, GAAP records Accounting Goodwill as an asset that loses value during its amortization period.
This is why he says to ignore Amortization costs when your EVALUATING the degree of Economic Goodwill.
Just to let readers understand better, GAAP understates the earning powers of assets in most cases where there’s a valuable franchise such as Mcdonald’s. For Mccdies, we can conclude that although Accounting Goodwill is setup as a cost during its lifetime, it is not a true economic cost
=> Why not? Just ask yourself if Mcdonald’s NAME is more valuable today , then its name was over 5 decades ago? Clearly, you can conclude that economic goodwill , in general, rises but GAAP states it as if it Goodwill was less valuable.
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Hi All
Need some clarification on the definition of ShareHolder Equity ?
Q) Do we include the Minority Interest & deffered tax liability in the calculation for share holder equity if yes
where these items appears on the liability side or assets side. Can we take the shareholder as:
ShareHolder Equity: Fixed Assts current Assets Minority Interest Deffered Tax Liability
– All loans (secured & unsecured) – current Liabilities
Q) Are the terms Shareholder Equity, Networth, Book Value same or there is a subtle difference among them ?
Thanks
Ajay
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Look fat the Johnson and Johnson (JNJ) Valuation here: http://www.fwallstreet.co...
Also here is a useful tool (loosely) based on Joe’s methods by a blogger named Sanjay Shetty: http://indiainvestor.word...
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Thanks for the information.
I’m familiar with SMF addin and have used it prior to upgrading to Office 2008 and Vista. I didn’t think it worked with the new versions but it does. You motivated me to fix a few problems.
For anyone who wants to try this on
be sure to download version 1.1 which is just above the comments section.
I just got it working. I’m glad that I now have a way to evaluate a company. I think I can now answer my own question on a previous post as to why Monhnish sold Stamps.com (STMP).
It’s not worth the current price even though the earnings webcast sounded good to me. I removed my open order at 9.50. The program says buy under $5.89.
I don’t understand some of the analysis yet. APOL for example is selling for $56 per share. The program says it’s worth $161 and to buy it under 121.
Steve
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Steve,
The model is most sensitive to the median free cash flow growth, as well as the latest FCF number, from which all the calculations are based.
For the example of APOL, you’ll see that the median FCF growth is well north of 20%, so you would be assuming continued growth at that rate in calculating the fair value. This may or may not be realistic, you’ll have to use your judgment. I actually created a “user growth” cell where I can input my own values and be a bit more conservative in the future growth assumptions if they seem unlikely to be repeated.
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Should we be worried about the Sub-Prime effect on our investments? Since the whole stock market is affected wouldn’t it also affect even good listed stocks?
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