WHAT'S A STOCK REALLY WORTH?

I devoted chapter 9 to the views of a bunch of academics called the ‘efficient market theorists'. Their theories run counter to the concept of emotion-driven price distortions. They'll tell you a stock's market price and its value are one and the same — that the market price is determined by the collective judgement of all investors active in that stock, that their buy and sell orders register their vote and the influence of this collective wisdom keeps stock prices aligned with their true value.

It's an attractive argument but it begs the question: is the collective judgement of market participants worth paying attention to? It could be if you believe an assumption underlying efficient market pricing, that investors are members of a rare breed of humans called Homo economicus — a sect of emotion-free, rational robotrons capable of making judgements as coldly and precisely as an IBM computer. Unfortunately that's where the whole price-equals-value argument starts to break down. The reality is that Homo economicus doesn't exist. He's like the Yeti or the Loch Ness Monster — talked about but never seen. The fact is people are capable of making very irrational decisions, particularly when taking their cue from hordes of others doing exactly the same.

Emotions and bias do affect judgement. Therefore emotions and bias do affect stock prices. Remember these are prices set by investors who, in their spare time, are probably out there buying Cabbage Patch Kids for their children. If you choose to run counter to the views of the efficient market theorists, and you believe that price and value do diverge, then you need to develop skills in valuing stocks, because without them you'll just run with the pack.

CALCULATING INTRINSIC VALUE

The term intrinsic value refers to an asset's underlying or real value, as distinct from its market price. More than anything it's a concept, but unfortunately it's a concept that gets terribly abused. For example, you often hear absolute statements being made like ‘The intrinsic value of Acme Corporation is two dollars and three cents'. When I hear comments like this I have to ask, ‘Where did the three cents come from?' The reality is it's not possible to pin a specific number on intrinsic value, so let's explore what intrinsic value really means, starting with some definitions.

The Chartered Financial Analysts Society defines intrinsic value as: ‘The value that an investor considers on the basis of available facts, to be the true or real value that will become the market value when other investors reach the same conclusion.' This definition delivers an idea of what it is, but ‘true or real' are just words. When investors think about intrinsic value they have a burning desire to quantify things. And this definition certainly doesn't tell us how that can be done.

Let's look at another definition, this time from Warren Buffett: ‘It is the discounted value of the cash that can be taken out of a business.' Closer, but it still doesn't help that much. Again it's a conceptual, not a practical, definition. In fact it's so impractical that Buffett doesn't bother relying on it too much himself. In 2008 Buffett biographer Alice Schroeder stated in a presentation at the Darden School of Business that Buffett ‘doesn't do any kind of discounted cash flow models or anything like that'.

This confirms a comment once made by Berkshire Hathaway's Vice-Chairman, and Buffett's long-time friend and business partner, Charlie Munger. At the 1996 Berkshire AGM he stated, ‘Warren talks about these discounted cash flows. I've never seen him do one.' Buffett's immediate response at that meeting was, ‘It's true. If a company's value doesn't just scream out at you, it's too close.'

Schroeder also made the following comment when describing the analysis Buffett used to back a decision early in his career to invest in Mid-Continent Tab Card Company: ‘He relied totally on historical figures with no projections. I saw him do it over and over again.' No models, no projections and no discounted cash flow, just a determination of profit margins based on historical data.¹¹⁷

Schroeder and Munger are two people who, by any measure, should have the inside running on how Buffett values a business, particularly Munger. It's interesting then to read the notes to the financial statements in Berkshire's 2011 annual report, which outline how Berkshire calculates the fair value of its reporting units when judging the need for any impairment of goodwill:

There are several methods of estimating a reporting unit's fair value, including market quotations, underlying asset and liability fair value determinations and other valuation techniques, such as discounted projected future net earnings or net cash flows and multiples of earnings. We primarily use discounted projected future earnings or cash flow methods.

Does the ‘we' stated here include Buffett? Or is it a generic ‘we' that refers only to Berkshire's accountants? And is this method applied only to the assets on Berkshire's balance sheet or is it a tool Buffett uses to size up potential stock investments and acquisition targets? It seems this apparent contradiction between how Buffett defines intrinsic value, how assets on Berkshire's balance sheet are valued and what Munger and Schroeder are on the record as saying about how Buffett values investments might not be a contradiction at all. Accounting standards define how assets are valued for the purpose of financial reporting, and regulatory frameworks stipulate that these standards are adhered to. And while Berkshire's accounts might value assets a certain way Buffett isn't required to dance to the same regulatory tune when undertaking his own valuations. He knows that most cash flow predictions deliver pretty rubbery figures.

So if formula-derived figures can't be relied upon, should we be using ‘intrinsic value' to describe them? To the uninitiated the term conjures up images of precision. Ben Graham acknowledged the problem, referring to the values analysts calculate not as intrinsic values but as ‘formula values'. Graham preferred to characterise intrinsic value as ‘an elusive concept' — and there's no calculator I've ever seen that, after keying in the necessary figures, displays the answer ‘elusive concept'.

I like US economist Paul Samuelson's description of intrinsic values. He referred to them as ‘shadow prices' and as ‘prices never seen on land or sea outside of economics libraries'. He acknowledged they couldn't be observed or calculated, yet insisted it is necessary to assume they exist.

It's worth reading the above comments again. Because the term ‘intrinsic value' is thrown around so freely these days, it's easy to fall into the trap of believing it has a rock-solid identity. It doesn't. But, as Samuelson says, investors need something to work with. So how do we deal with all this uncertainty? Answer: calculate intrinsic values if you must, but allow a big margin for your calculation to be wrong. You cannot deny the near certainty that your calculations will be wrong, but your quest should be for your calculations to be ‘less wrong' than the market's.

In Security Analysis Graham described intrinsic value as the ‘value justified by the facts'. That's fine, but what did he mean by ‘facts'? There's nothing factual about the future, and it's the future that intrinsic value is trying to get a handle on. So what is Graham suggesting? Let's look elsewhere for a clue.

Charles Dow referred to facts in an editorial in The Wall Street Journal on 22 March 1902. He saw the first requisite for analysis as ‘the existence of such figures as will disclose the vital facts'. He felt there needed to be a number of years of facts for analysis to be valid; that is, he felt more confident about peering into the future if there was plenty to see in the rear-view mirror.

The essential use of intrinsic value is to compare it with the prevailing market price to see if the market is presenting opportunities to either buy or sell. Joseph de la Vega's writings show that Dutch investors were doing exactly the same thing more than 300 years ago. And Thomas Gibson wrote in 1910: ‘Prices frequently become divorced temporarily from values … It is when prices are lower or higher than values, present or prospective, that we have our greatest speculative opportunities.'¹¹⁸

The encouraging news is that even the world's most successful investors freely admit they're unable to nail precise figures on intrinsic value. Investing is never a process of certainty or precision. It's more like the game pitching pennies where players pitch a coin at a wall. To win, your coin doesn't have to actually make contact with the wall. You'll rarely be spot on — you just have to get your coin closer to the wall than the other players do. Similarly, investors attempt to derive intrinsic values that are closer to true value than the market price indicates. Plenty of times successful investors get it wrong; they just need to be less wrong and/or wrong on fewer occasions.

FROM CLICKS TO CHICKS

Despite the lessons of the 1920s and the 1960s, it happened again in the late 1990s, when the dot-com bubble corrupted the assumed financial wisdom and replaced it with collective stupidity. The stories of newly created corporate shells being floated on the stock markets of the world with no business plan beyond ‘Let's rob these patsies blind, watch the share price fly, cash in our chips and get out of here as quickly as possible' make for fascinating reading.

The dot-com con was eerily similar to the South Sea Bubble of 1720. That era also saw pupil-popping prices paid for start-ups with mission statements that should have led with the words ‘unfounded hope'. It's worth quickly revisiting the South Sea Bubble, because there was one Cockney corporate con man of the era who requires his own special place in history.

Picture early 18th-century London. With no formal stock exchange, share trading took place in the labyrinth of narrow streets bounded by Cornhill and Lombard streets called Exchange Alley. It was 1720 and England was witnessing a raging bull market, and as with every bull market since there was a wave of new offerings in start-up companies. Some were legitimate businesses, many weren't. The crazy offerings were unaffectionately known as ‘bubble companies'. But of all the bubble offerings of the time one stands above the rest. Its promoter saw an opportunity to make a quick buck and, without any idea of what line of business his new company might undertake, hurriedly cobbled together a prospectus describing it as ‘A company for carrying on an undertaking of great advantage but nobody to know what it is'.¹¹⁹

Now we've all heard of the problems associated with a lack of corporate transparency, but this prospectus took things to a whole new level. The promoter's only saving grace was that he actually admitted to it!

The promoter of the bogus company collected £2000 in deposits from unwary investors in a single day and then did a runner — never to be seen again. And while you might see this story as amusing, if a little archaic, it carries a powerful message, particularly for those who believe that today's ‘sophisticated investing public' would never be so gullible as to fall for such a trick. The reality is that the same thing happened only recently.

In 1999, near the peak of the dot-com bubble, a company called NetJ.com Corporation filed documents with the US Securities and Exchange Commission stating, ‘The company is not currently engaged in any substantial activity and has no plans to engage in such activities in the foreseeable future'.

Sound familiar?

The $110 million capital raising was oversubscribed as profit-hungry investors dived in. NetJ's share price climbed 18-fold within months. But those who still held their NetJ shares in the wake of the dot-com bust lost their shirts. NetJ, not surprisingly, went belly up. What was NetJ's intrinsic value during the time it was trading? The same as the 1720 float described above — that is, zero. Simply using Graham's concept of ‘the facts' would have told people that.

Now dial the clock forward to 2012, to a time when corporate profits were waning and investor sentiment was at a low ebb. In early 2012, I was attempting to value Collins Foods, a company that holds two principal businesses — a string of Sizzler restaurants and over 100 KFCs. Seemed like a safe bet. Selling buckets of fried chicken has been a proven business model since the Colonel first dropped a drumstick into his deep fryer back in 1930. The multiple franchise owner I was valuing had floated on the ASX several months earlier at $2.50 per share, but it was now trading at around $1.20. The share price had collapsed following an announcement that the company's next profit result was likely to be at the lower end of expectations. On that news, investors bolted for the doors. When the dust finally settled the stock was sitting on a grossed-up prospective dividend yield of 14 per cent at a conservative payout ratio of 50 per cent, and all this based on a business franchising model that had been operating successfully for 60 years. Compare the value reasoning here, where investors dumped a perfectly good stock just because of one announcement, to the dot-com craziness from 13 years earlier, when investors were willing to throw cash at a company with no intrinsic value at all!

To my mind the valuation pendulum had swung fully to the other side of the clock case. The behaviour of those who sold out their shares in Collins Foods on the basis of a reaffirmed profit forecast is well characterised by the following 300-year-old quote: ‘They are all in haste to sell out, at more than half below the real Value, and will not wait with Patience and cool thoughts for the profitable Dividends.'¹²⁰

There's that all-important word ‘patience' again. So why the different views on value between the heady dot-com years and post-GFC 2012? The answer can be distilled into one simple word — sentiment. It's the second of the two important factors driving share prices.^a

Before leaving this story there's one more important point I want to make. Despite the share price of Collins Foods being less than half its float price, despite its offering a grossed-up dividend yield of 14 per cent, its share price continued to languish for a year and at one point was as low as $1 per share. Why?

It's because investors will begin to accept a stock price as being correct even though the available information appears to contradict it. They put more faith in the market price than their own valuation. They convince themselves that the share price must be sitting at a low level for a reason, one they've failed to identify. It's a bit like the farmer who opens the gate of a paddock to allow a flock of sheep to move out. They stand there blankly staring at the opening; since the other sheep aren't moving it's as if the opening doesn't exist. The problem is, if you behave this way opportunities will never be taken. Cheap stocks will never be bought. To profit from opportunity you need to have faith in your judgement and the conviction to act independently.

Here's why most people simply can't do that.

SOLOMON ASCH AND SPINNING WHEELS

In 1952 psychologist Solomon Asch conducted a now-famous study on how much we are influenced by other people's thinking. He coached groups of seven to nine participants to provide the wrong answer to a series of simple questions. Then a patsy was brought into the group, someone who wasn't privy to what was about to happen. Twelve simple questions were put to the group, to which the trained members unanimously provided incorrect answers. On one-third of occasions the unwitting ring-in also provided the incorrect answer, and this was in response to really simple questions with obvious answers like: ‘Look at these two lines. Which is longer, A or B?'

If people can be influenced by the group to deliver incorrect answers to questions with obvious answers, then how would you expect them to perform in the uncertain world of financial markets, where answers to questions are far from obvious? The influence of groupthink on their conclusions is extremely powerful.

Psychologists Daniel Kahneman and Amos Tversky have undertaken studies along similar lines and have found that totally irrelevant information can influence the decision-making process. They performed a study where participants witnessed the spin of a wheel-of-fortune just prior to answering a question requiring a numerical answer. If the wheel showed a high number, they were more likely to give higher numbers when answering the unrelated question.

Kahneman describes another study where a group of visitors to the San Francisco Exploratorium were asked two questions:¹²¹

• Is the height of the tallest redwood more or less than 1200 feet?
• What is your best guess about the height of the tallest redwood?

A second group was asked:

• Is the height of the tallest redwood more or less than 180 feet?
• What is your best guess about the height of the tallest redwood?

Despite the second question being exactly the same for each group, the difference in mean estimates between the answers given by the two groups was staggering. For the first group it was 844 feet, while for the second it was 282 feet. People weren't even given the answer to the first question — it merely planted a suggestion. No wonder investors have trouble deriving their own independent value for a stock!

This behaviour carries the fancy title of the ‘anchoring and adjustment heuristic', and it's rife in financial markets. When economists are asked for their views on the economic outlook, they base their judgement on present conditions. Analysts who value stocks are influenced by the current market price. The investors best able to win at this game are the ones who can jettison all this emotional baggage, but it's a difficult thing to do. We are fighting millennia of evolution that got our brain working the way it does.

WHAT IS MARKET PRICE?

Investors, in their search for opportunities, are constantly studying the relationship between price and value. I attempted to define ‘intrinsic value' earlier in this chapter, so let's now explore what ‘market price' is. Most investors don't think too much about it. After all, the market price is just the market price. You can't control it — it's just there, so simply accept it. And to an extent that's true. But it's fun to think about it anyway, and along the way we can gain a better understanding of what drives it.

First off, the market for any stock usually consists of multiple potential buyers and sellers. I say ‘potential' because at any point in time most are simply observers. A single trade involves just two parties, the most optimistic buyer and the most pessimistic seller. And no matter what prices the other potential buyers and sellers are willing to act on, it's only the participants at the trading ‘coal face' who are setting the price at that point. John Burr Williams described this as the marginal opinion.¹²²

That means the market price is not equally influenced by the judgements of all those interested in buying or selling a stock. The market isn't a mechanism for processing the collective value judgements of all to produce a volume-weighted average price called the market price. Most value judgements don't impact the market price at all, and might never do so. What's more, the value judgement of many investors changes as the market price changes. The price/value relationship is a complex dynamic rather than a simplistic, unchanging comparison. For example, if someone believes a stock they own is worth $3.50 and intends to sell if it reaches $4.00, they might change their mind about selling if it does reach $4.00, believing it's now worth more.

WHAT DRIVES MARKET PRICE?

Investors have long stated that value is the long-term driver of a stock's market price. Typifying this belief is Ben Graham's oft-repeated comment that in the short term the market is a voting machine but in the long term it's a weighing machine. But it's a bit of a sticky point. If it's not possible to determine exactly what a stock is worth (its intrinsic value), then how do we know if the market price is approaching it? William Armstrong probably came close to the truth when he noted in 1848 that, although intrinsic value is the principal determinant in setting the market prices of securities, it's not the only factor involved.¹²³

The influence other factors may have on market prices varies significantly from one period to the next. What then are these other factors? The principal one is sentiment, but what shapes sentiment? Perhaps the best answer I've seen is — everything! Which of course adds to the difficulty of calculating, modelling or predicting it. Market prices can even react in opposite ways to what is essentially the same news. In the wake of the 2008–09 GFC, the US Federal Reserve undertook a series of programs of quantitative easing. In an effort to support the US economy it initiated bond purchasing programs that pumped tens of billions of dollars of cash into the US economy every month. The stock market loved it and prices were generally bid up strongly. But in May 2013 rumours spread that the program was soon to be eased back, and the market went into a tailspin. As the months progressed and the rumours didn't crystallise, the market not only recovered but proceeded to hit new highs. In December the Fed finally confirmed it was commencing the tapering process. The market's reaction? This time it rallied. Figure that.

I hear people say that at the most fundamental level, stock prices are driven by forces of supply and demand. It's an idea commonly put forward by technical analysts. Indeed Richard Wyckoff, stock market educator and founder of The Magazine of Wall Street, whom many look upon as one of the pioneers of technical analysis, had this to say more than 80 years ago: ‘I demonstrated the fact that the law of supply and demand controls the prices of stocks just as it does the prices of wheat, corn, labor and materials of all kinds.'¹²⁴ Wheat prices, as Wyckoff suggests, are subject to the forces of supply and demand. In fact, as I write this chapter the prices for the two largest US crops — corn and soybeans — have soared to all-time highs due to a drought-driven supply shortage, a case of plentiful dollars chasing limited supplies.

But stocks are different. The supply of stocks doesn't vary with drought, or much else for that matter. Excluding the exercise of options, new capital raisings and share buy-backs, the supply of stocks remains relatively fixed. The greater change is on the demand side. In bull markets, prices climb as enthusiastic speculators buy and sell stocks among themselves at ever-increasing prices. But as the enthusiasm dies so too do prices. There is little change in supply, but there is a substantial increase in greed-driven demand.

Of all the opinions and ideas I've read on what defines and drives the market price, I think Keynes came the closest to nailing it. In his Chairman's speech to the 1938 National Mutual Insurance Company annual meeting, he stated:

[Markets] are governed by doubt rather than conviction, by fear more than forecast, by memories of last time and not by foreknowledge of next time. The level of stock prices does not mean that investors know, it means they do not know. Faced with the perplexities and uncertainties of the modern world, market values will fluctuate more widely than will seem reasonable in the light of after-events.

Clearly Keynes, were he alive today, would have little time for the efficient market theorists.