By Investment Master Class

There’s lots of ways to think about value.  When I studied property valuation at university we were taught that value was “the estimated amount for which a property should exchange on the date of valuation between a willing buyer and a willing seller in an arm’s-length transaction after proper marketing wherein the parties had each acted knowledgeably, prudently, and without compulsion.”

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Unfortunately, in the stock market there is no one-size-fits-all definition of value.   It's worth focusing on market value, intrinsic value and private  value.  

Intrinsic value, also referred to as underlying or business value, reflects a company's worth and is probably most closely aligned with the definition of value in the opening paragraph.   A company is worth the discounted value of the future cash flows an owner will receive.  The Investment Masters focus on the free cash flows coming out of the business rather than earnings.

"In reality, earnings can be as pliable as putty when a charlatan heads the company reporting them" Warren Buffett

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"Cash flow, not reported earnings, is what determines long-term value" William Thorndike

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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.

“Intrinsic value, is in its simplest form the discounted present value of future cash flows” Frank Martin

"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"  Warren Buffett

“Bear in mind - this is a critical fact often ignored - that investors as a whole cannot get anything out of their businesses except what the businesses earn. Sure, you and I can sell each other stocks at higher and higher prices.” Warren Buffett

“Occasionally, people lose track of the fact that in the long run, shares can’t do much better than the companies that issue them”  Howard Marks

Those cash flows will be received in the future and the future is unknown.  Some company's cash flows are simpler to estimate like a REIT with contracted lease payments while other company's cash flows and much harder to forecast such as a new technology venture.   As future cash flows are uncertain it's impossible to ascertain a precise value for what a company is worth.  Therefore an estimate of a company's worth is a range and not a single figure.  In cases such as technology it may not be possible to estimate future cash flows which significantly raises the risk of investment.

"It is important to understand that intrinsic value is not an exact figure, but a range that is based on your assumptions" Jean-Marie Eveillard

“Calculations of intrinsic value, though all-important, are necessarily imprecise and often seriously wrong.  The more uncertain the future of a business, the more possibility there is that the calculation will be wildly off-base.” Warren Buffett

A company's intrinsic value is subject to changes in earnings expectations and changes in investor return requirements but really shouldn't fluctuate that much.  The more certain the cash flows the more stable the company's intrinsic value.  Intrinsic value tends to be far less volatile than a company's market value.

"Value to some extent is in the eye of the beholder. It is very hard to pin down what the value of a future set of cash flows from a business, be it a cable TV or biotechnology, is going to be. Some are easier to predict than others.  But it is very hard to predict what those future cash flows are going to be.  And it is very hard to ascertain the correct discount rate to bring them back to the present with." Seth Klarman

As cash flows are inherently unpredictable, its makes sense to be conservative when making estimates.  The more conservative the estimates the greater the margin of safety.

“Obviously, we can never precisely predict the timing of cash flows in and out of a business or their exact amount.  We try, therefore, to keep our estimates conservative and to focus on industries where business surprises are unlikely to wreak havoc on owners” Warren Buffett

"When we look at value, we tend to look at it on a very conservative basis - not making optimistic forecasts many years into the future, not assuming growth, not assuming favourable cost savings, not assuming anything like that.  Rather looking at where it is right now, looking backward and saying, is that the kind of thing the company has been able to do repeatedly? Or is this a uniquely good year and is it unlikely to be repeated?"  Seth Klarman

Market value is the value of the company at any one point in time determined by the share price.  Market value for a company is the last share price multiplied by the number of shares on issue.  In reality, market value can be, and often is, significantly different from both intrinsic value and private value.  Just because a stock trades at a certain price does not mean the company is worth that amount.  If you have a small parcel of shares you may be able to achieve that price.  If you own a large stake in the company it may not be possible to sell them all at that price.

"The underlying value of a security is distinguishable from its daily market price, which is set by the whim of buyers and sellers, as are the prices of rare art and other collectibles” Seth Klarman

Market value can be significantly above intrinsic value.  Plenty of people pay more for companies than they are really worth.  This may occur when they expect someone else to pay even more [ie they are speculating], they have unrealistic growth expectations, they have an investment mandate that means they have to buy, they are focused on the short term outlook, they are too optimistic, or they believe the share price looks cheap relative to other companies etc.

Conversely, a company's market value can be significantly below intrinsic value - the future maybe uncertain, macro factors maybe overwhelming fundamentals, investors maybe focused on the short term outlook, investors may be acting irrationally, or investors may have a mandate requiring them to sell the shares etc.

“Mr. Market gives you opportunities

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