What is the Value of Stock?
Ben Graham Graham states in the preface of The Interpretation of Financial Statements, "if you have precise information as to a company's present financial position and its past earnings record, you are better equipped to gauge its future possibilities. And this is the essential function and value of security analysis."
Professor Greenwald who teaches the value investing course at Columbia
University and also authored, Value Investing: From Graham to Buffett and
Beyond, says in an interview, "The Graham technology is starting with the most
reliable information, which is asset value, then looking at the second-most
reliable information, which is current earnings -- with all the appropriate
adjustments and getting an earnings-power value -- and then looking at those
two and see what they tell you about the extent to which you are buying a
franchise, which is value in excess of assets. And then, only then, looking at
the growth. I think that's far superior than doing an undiscriminating cash
flow analysis, where you can't really tell what the crucial assumptions are. So
good value investors then bring a first-rate valuation discipline to the
market."
To understand the real long-term earnings power of the business consider their reported earnings excluding irregular items such as earnings from discontinued operations, extraordinary items, unusual gains or losses, and accounting changes as well as the cash flow from operations which represents cash from normal ongoing operations. The cash flow from operations metric adjusts earnings for operating gains and losses that are non-cash items. These metrics eliminate the financial engineering and irregular items such as large write-offs or irregular gains that cloud an investors ability to see the business's real earnings power.
When an investor has an informed expectation for the changes in the factors affecting earnings; the investor can roughly project the future earnings over the long-term by starting with the past earnings and making adjustments due to changes in these factors.
Ben Graham lectures on the technique of determining the expected earnings saying, "As far as the use of earning power or earning prospects in Wall Street is concerned, let me point out that in most of the current thinking earning power is not considered along the lines of an average over a period of time of medium duration. It is either considered as the earnings that are being realized just now, or those right around the corner, such as the next twelve months."
"It is now becoming approved practice in any really good analysis to work out the future earning power along somewhat independent lines, -- by considering afresh the most important factors on which the earning power will depend. These factors in the ordinary case are not very numerous."
"In the typical case, therefore, it is worthwhile for the analyst to pay a great deal of attention to the past earnings, as the beginning of his work, and to go on from those past earnings to such adjustments for the future as are indicated by his further study."
Warren Buffett continued on Graham's line of thinking by categorizing businesses into either strong/weak franchises or strong/weak commodity businesses to get a better idea of their long-term earnings prospects.
Strong/Weak Franchise Business
By this Warren Buffett means a company which is providing a product or service
that is needed or desired, has no close substitute, and posses a great amount
of economic goodwill. A company with a strongest franchise can regularly
increase its prices without fear of losing market share, even when demand is
flat, enabling it to have great long-term earnings. The strong franchise
business is the business whose brand name is captive to the consumer.
Strong/Weak Commodity Business
Warren Buffett considers any businesses that produce similar products with many
competitors or where consumers show little brand loyalty as commodity
businesses. To varying degrees, consumers simply choose these products based on
the best price available. The strong commodity business with good long-term
earnings prospects is the lowest-cost supplier which has economies of scale.
The True Stock Value Approach considers the level of differentiation and demand for the business' products and services.
The level of differentiation from competitors depends on whether competitors can develop similar brands, economies of scale, and technological advantages as the business. The longer a business can maintain differentiation by brand, economies of scale, and technological advantage, the longer they can receive the higher earnings that come with having unmatched competitive advantages.
Brand
A brand leads to mind share and customer captivity for a certain good or
service. A brand provides a business with the pricing power to increase prices
without significant loss in volume or market share.
Economies of Scale
Economies of scale lead a business to have a lower cost of production per unit.
Economies of Scale provides a business with the ability to accommodate large
increases in volume with lower increases in costs.
Technological Advantage
Technological advantages are developed from having patent protection or a very
complicated process that competitors can't replicate. Technological advantages
provide a business with a unique value to consumers.
The True Stock Value Approach also considers the level of demand for the business' products and services.
Demand
Consumers have certain desires and they demand products and services that most
effectively fulfill those desires. The new demand and reoccurring demand are
the two factors to consider in analyzing the demand.
New Demand
The New Demand depends on whether the business can expand from existing markets
to new markets.
Reoccurring Demand
The Reoccurring demand depends on the length of time that the product or
service can provide utility for the consumer. The longer the product or service
can satisfy consumers the lower the reoccurring demand for the product.
If an investor broadly understands the changes in the factors that affect future earnings: level of differentiation from competitors and level of demand, they can roughly determine the business' long-term value. The more complex and shifting these two factors that affect future earnings are, the harder the task of determining the business' value.
Warren Buffett in his 1994 Annual Report says, "Investors should remember that their scorecard is not computed using Olympic-diving methods: Degree-of-difficulty doesn’t count. If you are right about a business whole value is largely dependent on a single key factor that is both easy to understand and enduring, the payoff is the same as if you had correctly analyzed an investment alternative characterized by many constantly shifting and complex variables... Our investments continue to be few in number and simple in concept: The truly big investment idea can usually be explained in a short paragraph. We like a business with enduring [differentiation] competitive advantages that is run by able and owner-oriented people."
Who makes Value Stock Picks
What is the Value of Stock
Where do I Determine Stock Value
When are there Stock Market Values
Why do I Base My Investments on Value
How Do I Determine Stock Values
Diversify To Where You Are Comfortable With Daily And Even Yearly Price Fluctuations
Never Risk Money You Can't Afford To Lose
Be Fearful When Others Are Greedy and Greedy When Others Are Fearful