In order to understand what the intrinsic value or fair value of a common stock is, you must think like a long-term business owner and not like a stock trader.  Additionally, you must think like a business owner that has no intention of selling their business.  Put another way, your business generates your livelihood. Therefore, your primary focus and attention is on answering the question: how’s business?

When you own your own business you care about sales, cash flows and ultimately net profits.  These are the things that make your business valuable to you simply because these are the things that produce your income.

Valuation is a Mathematical Principle and Not a Vague Concept

When I speak of valuation, I am referring to the mathematical calculation of the returns (including both capital appreciation and dividend income) which you could prudently expect to earn from the company’s cash flows (earnings). Those returns should be large enough to compensate you more than you could earn from a theoretically riskless investment like a Treasury bond.  If you are not being compensated for the extra risk you’re taking by investing in stocks, then I believe you are paying more than you should be.

“Price Is What You Pay. Value Is What You Get”

The venerable investor Warren Buffett has a real knack of putting complex concepts and ideas into simple and easily understood terms. In my opinion, his quote, “Price is what you pay. Value is what you get” is one of the more profound and important statements he has ever uttered. If truly understood, these simple words represent perhaps some of the most important bits of investment wisdom that an investor in common stocks could ever receive.

The concept of fair valuation represents the key to receiving the full benefit that these wise words provide. Knowing the price you pay is simple and straightforward. And, although many have an intuitive understanding of value, its deeper meaning is often only vaguely comprehended. Anyone who has truly made the effort to study Warren Buffett’s investment philosophy understands that receiving value on the money he invests is of high importance to him.

So how do you know, when buying a stock, if you’re getting value or not for your money? I contend that the answer lies in the amount of cash flow (earnings) that the business you purchase is capable of generating on your behalf. And regardless of how much cash flow the business can generate for you, its value to you will be greatly impacted by the price you pay to obtain it. If you pay too much you get very little value, but if you pay too little then the value you receive is greatly increased.

Therefore, if value is what you’re looking for, then it’s important that your attention be placed on the potential cash flows that you’re expecting to receive. Unfortunately, few investors possess the presence of mind to focus on this critical element. Instead, investor attention is more commonly and intensely placed on stock price and its movement. A rising stock price is usually considered to be good, and a falling stock price is considered bad.  However, prudent investors understand, recognize and acknowledge that the stock market often incorrectly prices the stock behind a business relative to its intrinsic value.

Another investing great offered his view on this important point: “Just because you buy a stock and it goes up does not mean you are right. Just because you buy a stock and it goes down does not mean you are wrong.” Peter Lynch ‘One Up On Wall Street’

Just like the Warren Buffett quote, Peter Lynch’s quote is also based on the principle of sound valuation. The point is that a rising stock may be dangerously overvalued, while a falling stock price may indicate that the company is becoming a rare opportunity on sale.

Knowing the difference will materially impact not only the long-term rate of return the investor receives, but perhaps more importantly, the risk they are taking to get it. As I will illustrate later, you can dramatically overpay for even the best company. It is a truism that the stock market can, and will, inaccurately appraise the value of a business from time to time – up or down.

From what has been said so far, it should be clear that in order to receive value, you have to know how to calculate value. Then, and only then, can you be absolutely certain that you’re investing in a stock and receiving value for the price you pay. However, there is an important caveat that needs to be introduced.

Just because you buy a stock at value doesn’t necessarily mean that you will receive a high return. This is because value, although important, is only one component of future return. The other important component is the earnings growth rate of the business.

To clarify, you can buy a slow-growing company at sound valuation, and even at the same valuation as a faster growing company, while still earning only a modest rate of return. In fact, it could be argued that only being willing to invest at sound valuation is more critical for a slow grower than it is for a faster grower.

The rationale here is that there is very little margin for error when investing in a low growth security. Therefore, it’s even more imperative that you get valuation correct. This may be one of the most confusing aspects of fair valuation, or value, that I will elaborate on later.

The Foundational Principles of Value

What gives a business (stock) value? Ultimately, any business, public or private, has its value derived from the amount of cash flow it is capable of generating for its stakeholders (stockholders). Not only will capital appreciation depend on the level of earnings, dividends are also a function of earnings. It is because of this principle that the discounted cash flow (DCF) method of valuing a business is so widely-accepted by scholars and professional investors.  Consequently, this article on how to value a business is strongly based on utilizing fundamental valuations based on cash flows (earnings) as the primary method for assessing fair value or True Worth™ as I like to think of it as. 

However, I intend to spare the reader the tedious task of evaluating or calculating long and complex mathematical formulas in order to assess fair valuation. Instead, I will focus on presenting logical explanations and straightforward discussions of the principles behind these important valuation methods. Additionally, I will provide what I hope the reader finds as easy-to-understand pictures as evidence supporting my points.  Anyone who is interested in a more scholarly approach can simply Google: How to value a company using the discounted cash flow method (DCF).