Price vs. Value
Benjamin Graham, one of the early followers of fundamental analysis based investing and also Warren Buffett’s professor, had propounded the concept of Mr. Market way back in the nineteen forties to describe the contradictory and irrational traits of investors. Graham described Mr. Market as an investor prone to erratic swings of pessimism and optimism and since majority of the stock market is comprised of such investors, he felt that the market as a whole takes on these characteristics. His advice was that while Mr. Market creates ups and downs in stock prices all the time, prudent fundamental investors should remain unfazed by these and keep looking at the larger, long-term picture.
Not much has changed over the last century as investors continue to exhibit the same behavior as Graham had described. Once in a decade or thereabout we witness a huge drawdown in stock prices with investors nervously dumping their stocks at any price and running away on account of the perceived risk to the economy and its growth. While the reasons for these huge drawdowns are always different but the end result is usually the same i.e. stock prices falling thirty to fifty percent. It is during such times that investors have to sit back and think in a very cold and calculating manner about the relationship between the value of a stock and the price at which it is trading. The attempt of this article is to bring to light the huge departure between the damage to the value of a business on account of an economic crisis and the fall in its stock price.
The intrinsic value of a business in its most fundamental sense is nothing but the present value of all the cashflows that the business will generate through its life. Let’s break the life of the business into two parts; the first twenty years and then beyond these twenty years. While most investors cannot think beyond the next couple of years, it is only fair to assume that it is difficult for any investor to project the cashflows beyond the first twenty years. However, businesses are going concerns and a well-managed business is expected to be around for a very long time, fifty years or even more, and it is for this reason that we need to ascribe a value to businesses beyond the first twenty years. Let’s call this value as the perpetuity value of the business. While we don’t intend to get into the calculation of this perpetuity value but it is worth mentioning here that the range of perpetuity value for various businesses across industries is usually between twenty five percent to fifty percent of the total value of these businesses.
So let’s take the perpetuity value of a typical business to be around thirty-five percent. Make another assumption that the business we wish to value is resilient enough to survive the economic crisis and though it would witness reduction in profits and cashflows during the crisis years but it would once again come back to its normal rate of profits and cashflows after a few years. It is therefore only reasonable to expect that no economic crisis, including the ongoing COVID-19 pandemic, can impact the perpetuity value of a well-run business. Thus, about thirty-five percent of the total value of a typical business is insulated from any economic downturn or slowdown.
Let us now talk about the remaining sixty-five percent of the value of the business that is being derived from cashflows generated during the first twenty years of the life of the business. To keep it simple, let’s assume that the business is not witnessing any growth and therefore its cashflows per annum are constant, say Rs 100 per annum, for the entire twenty-year period. To keep it simple again, we also don’t discount these cashflows which means that the present value of each of these cashflows through the twenty years is Rs 100. The value of the business thus becomes 20 multiplied by 100 which is Rs 2000. This is the value of the business pre-economic crisis. Let’s now suppose that an economic crisis hits the economy and all businesses are going to be severely impacted. To get more topical, let’s consider the present pandemic which has led to forced shutdown of the economy and although the economy has started to open up but it would take many quarters for the economy to normalize. Let’s make a conservative assumption that the impact of the virus spread would take a couple of years to get neutralized and as a result economic activity would suffer for two full years and the cashflows of our business would reduce to half during these two years (Rs 50 per annum) but would come back to normal (Rs 100 per annum) from the third year. On this basis, the value of the business post the economic crisis reduces to Rs 1900, a reduction of five percent. Actually the reduction in value is even lower. Remember we had said that thirty-five percent of the value of the business which is being derived from its perpetuity value is insulated from the crisis. What has been impacted to the extent of five percent is the value of the business for the first twenty years. If you do the math you would realise that the total intrinsic value of the business comes down by only three percent.
This is all that the common investor needs to know about the loss in value of a business whenever an economy is struck with a crisis leading to either a recession or a slowdown in growth. The loss in value of the business is usually in single digits but the fall in prices is often thirty to fifty percent if not more, leading to a great opportunity for the emotionally balanced and long term oriented investor who is only focused on the fundamental value of the business rather than trying to gauge how other investors would react to the short term news flow.
By the way, for the more nuanced and academically inclined investor who wants to consider different scenarios of growth in cashflows over the first twenty years and an appropriate discount rate to find the present value of these cashflows, the reduction in value under different scenarios works out to between three percent to ten percent. Again if you do the math, you would realise that the total intrinsic value (including the perpetuity value) comes down by only two percent to six and a half percent under different scenarios.
This above model is not just applicable during times of economic crisis. One can apply it equally effectively during times of economic expansion and concomitant stock market euphoria to avoid buying a business at a price substantially higher than its intrinsic value. During such phases, investors need to keep in mind that periods of super normal growth are unsustainable in the long run and should not be extrapolated. This in turn implies that the impact of high growth for a few years on the total intrinsic value of a business would at best be in single digits.
The Human mind is not conditioned to think about the long term, on the contrary it gets heavily influenced by the happenings right now and right here and extrapolates them. As an investor, we have to train our minds to think about the long term and not by the current happenings which are usually fleeting. Like Benjamin Graham said, you need to take advantage from the behavior of Mr. Market and not get influenced by it.