Price is what you pay, value is what you get. – Warren Buffett
For those who may not know, Mr. Market is the allegorical brainchild of Ben Graham, the man widely considered to be the grandfather of the value investment philosophy, Warren Buffett’s mentor, and the author of some of the best-selling investment books of all time in The Intelligent Investor and Security Analysis. Mr. Market was devised by Ben Graham in order to convey the immense importance of the price to value relationship in buying marketable securities, and how your ability to rationally separate the two can offer you great opportunities when undertaking the endeavor of attempting to “beat the market.”
Before I get into more detail on Mr. Market, I’d like to define a couple of key words, and perhaps more importantly their underlying concepts, and why it is important to understand them.
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What is value? Beings that I will stick to business and business value in this discussion I will use one key phrase in referring to value, and that is the concept of intrinsic value. So what exactly is the intrinsic value of a business? To put it simply the intrinsic value of a business is the underlying value of all assets, tangible and intangible, of the company. (Or in financial terminology) Intrinsic value is the present value of the earnings that can be generated and extracted from a business from now until eternity that has been discounted at the proper discount rate.*
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What is Price? The price of a business, especially a publicly a traded one, is much easier to find. Generally just a quick search into your favorite search engine can give you the price of whatever stock you’re interested in. The only thing the price of a stock indicates is what others have been willingly to buy and sell it for in the very recent past. So essentially, the price is just what you are required to pay in order to attain whatever it is you are seeking to purchase, and in the case of this discussion, we’ll just say it’s a tiny fraction of a business known as a stock or share.
Though the difference between the two can often be fuzzy, and often times there may not even be a difference between what the market says a business is worth and what you find the underlying value of the business to be worth, but there will be times that a significant divide between the two will be evident. And this is where Mr. Market comes in.
Let us assume Mr. Market is your business partner, and each of you own 50% of a business, and the intrinsic value of this business happens to be worth roughly 100 dollars. Unfortunately, the poor guy suffers from bipolar disorder, and often times he will have rather vigorous bouts of mania, and frequent fits of depression. Fortunately for you, every day he shouts a price at you from across the room, asking you to buy his half of the business. On some days, when he is going through manic episodes he will shout, “$200! 150! 100!” and because you’re a savvy businessperson and you’ve already understood the price of the entire business to be worth $100, and beings that you already own half of it, there’s no way in the world his half is worth more than $50. Also, because you’re patient and understand that soon enough, Mr. Market is going to dive into an unfortunate depressive episode, he’ll begin to change his tune. Sure enough, sometime later as Mr. Market is yelling from his side of the room, his prices begin to differ, “$50! 35! 20!” And now of course is the time you’ve been waiting for! You can buy his half of the business for less than a quarter of what it is intrinsically worth, what a deal! As you can see from this example, regardless of the price that has been shouted in your direction, the value of the business never changed, so your willingness to pay a specified maximum price should never change; whether Mr. Market is happy, sad, or just relaxing in his corner doesn’t matter. What matters is what the business is worth, and how much you are willing to pay.
When it comes to the actual market, the approach should be no different. It does not matter whether a business is going to grow at 50% per year, 100% per year, or a measly 1% a year, what matters is whether the market price is in step with the business’ true value, and if it isn’t, then you may have a great opportunity on your hand, and if it is then keep the price that you are willing to pay for it in the back of your head until sometime in future when it may fall in line with what you have in mind.
Finally, the market is there to serve you, and you should treat it as such. Just because analysts, talking heads on media platforms, or even your friends say a stock is a good buy, doesn’t mean it is. And just because a business is a good business, doesn’t mean you should buy it right away if the value of the company is already reflected in the market price, or worse yet, if the price is far above the value(though shorting may be an option).
*The proper discount rate is somewhat subjective, but most people tend to use a US treasury bond yield as their “risk-free” rate, usually the ten year, and add a risk-premium based off of the type of company and industry.
Submitted November 30, 2017 at 07:43PM by AdamSmithsActualHand http://ift.tt/2ALtbll
