#2 Investing 101: How To Think About Fair Value?
#2 Investing 101: How To Think About Fair Value?
If I were to pick only two central concepts in investing, they would be fair value and margin of safety. Understanding fair value will help you avoid permanent loss of capital.
I have thought about fair value since I started investing when I was in law school.
All my life, I haven’t seen one sentence that reflects the essence of fair value better than this:
“It’s not worth it.”
This was the subject of the sentence:
It was autumn 2022 and iPhone 14 had just been launched. I was talking to a friend and we both were using iPhone 11.
I asked him, “Are you going to upgrade?”
He was straight, “No, it’s not worth it.”
At the moment a lightning struck in my mind and I thought that people have a inner compass to find fair value.
When we say “it’s not worth it” we actually come up from a hypothetical price point that we think is fair for the product or the service offered.
We do it intuitively. When you break it down, it follows this path:
We just look at what we have.
We look at what is offered as a substitute.
We understand the premium asked for the substitute.
We evaluate whether we are willing to pay the premium for extras in the substitute.
There is a price level that we deem appropriate for the extras. If offer is above that level we don’t take it. This is the essence of fair value.
🔢 Fair Value Is A Range
Fair value is not a particular price point. It’s more often a price range.
People rarely say “$40 is the fair price I am not paying more.”
We often speak in ranges, “I can pay up to $100.”
That’s the fair value, it’s a range and we have a compass for it. This compass is built on experiences and learning.
If you go grocery shopping several times, you know bread shouldn’t cost $10, but you also don’t have a particular anchor price such as $1.50. You know that it may cost anywhere between $0.50 to $3 depending on the quality, size and packaging.
Anything within the range may be deemed “reasonable” while below the range would raise suspicion about the quality and above the range would feel excessive.
You accept the offer when it’s reasonable, you reject it when it’s outrageous.
In the stock market, however, people don’t often think this way. Why?
🏦 Fair Value In The Stock Market
People have that inner compass for fair value but this doesn’t mean it has to be right.
It may be right more often than wrong or vice versa, but the important thing is that we have it.
When it comes to the stock market, people suddenly lose this compass and it has to be rebuilt for investment success.
There are few reasons why we lose it:
Most people see stocks as tickers with no real value.
We don’t get a tangible benefit that we can put a price on.
Daily price movements make it hard to have a price anchor.
This list can be extended but these are the primary reasons I have observed in my investing career.
Luckily, if you read the first issue of this course, you have mental tools to overcome such illusions. You know:
Stock is a certificate of a partial ownership in a business, it’s not a ticker.
You have legal claims on the business that comes from stock ownership.
Daily price movements only occur because there are buyers and sellers.
You know that a value of share comes from the total value of the business which is directly correlated to its earnings.
This brings us to the concept of a “money printing machine.”
If you haven’t read the first issue of this course, here it is 👇
🖨️ Price Of A Money Printer
We talked about how we value things based on their benefit to us.
Benefit can be tangible or intangible.
A desk has a tangible benefit, we could eat and work on it.
A book has an intangible benefit, it helps us improve our brain.
As shareholders we are partial owners of the business so we have to think from the owners perspective.
What’s the benefit a business owner gets from his business?
It’s money. Business is essentially a money printing machine.
The question is “how can you put a price label on a money printing machine?”
Let’s go to the basics, how would you value a regular printing machine?
You would look at the per page printing cost in a copy center. (Let’s say $1)
You would look at the raw material cost for print per page. (Let’s say $0.60)
You would look at the lifetime printing capacity. (Let’s say 1,000 pages)
In this case, you would be willing to pay anywhere from $600 to $1,000.
This would be your price anchor and then you can adjust depending on your subjective preferences.
For instance, if you live far away from the copy center, you may even accept paying some premium and offer $1,100 for saving yourself from the trip.
You can make the adjustment but in any case your anchor for fair value would come from cost per print, life-time capacity and price of available options.
Think business as a money printing machine.
To find the fair value, you would sum all the money it’s going to print in the future and you would come up with a price you are willing to pay for it today, because money has time value.
This only gives you the price anchor though, it doesn’t tell you anything whether the asking price is reasonable or not. You have to look at the substitutes to understand that.
It is almost like calculating the raw material cost for bread. You know the price should bear some relation to that cost but you don’t actually know how much premium is generally charged. You go to the store and take a look at different breads to have an opinion.
Same happens with businesses or so-called “money printing machines.”
“Buy this machine for $100 today and get $300 five years after” looks more reasonable than “buy this machine now for $100 and get $1,000 twenty years later.”
In these cases, the answer to the question of “how much should I pay for those machines today?” is your fair value range.
💵 Fair According To What?
This comes back to the sentence that I paid my admiration in the opening of this writing:
“It’s not worth it.”
When we have a raw understanding of what extra we are getting by purchasing the money printer and the price requested, we should decide whether “it’s worth it” or not.
I explained that doing this requires a comparison with what we already have.
In the world of money machines, there are two machines that have never got broken until now:
US Treasury bonds.
Broad market index.
By buying US Treasury bonds you are basically lending money to the US government that guarantees its repayment. It doesn’t break by design. This is why it’s so safe.
The broader market has always gone up in the long term. Not by design but it has always done due to generally positive historical progression of human development. It is riskier than the Treasury bonds but still pretty safe.
Then there are thousands of other machines with different features but they can break, there is no guarantee.
Imagine:
The US treasury promises you $105 after a year if you lend it $100 now.
Broader market money machine (index fund) promises $110 a year later if you buy it now for $100.
Brand new machine (stock pick) promises you $180 after a year if you buy it now for $160. However, there is a risk that it can break.
In this case, you will have to adjust the price you are willing to pay for the brand new machine.
Returns look like that:
5% for the bonds,
10% for the index,
12.5% for the stock pick.
To find whether picking the individual stock makes sense, you have to calculate how much of bonds and broader market index you need to generate $180.
You would need:
$171 worth of treasury bonds.
$163 worth of broader market index.
Now it’s easier to say whether it’s expensive or not right?
You can buy $160 machine that can break or you can pay $3 more and buy $163 machine that doesn’t break. Both of them promises $180 after a year.
A reasonable investor would go with the safer option because saving $3 isn’t big enough to justify risk of losing money.
It’s not worth it.
If the new machine was selling for $120, for some reason, you could have taken the risk and go with that.
Also, if you didn’t have the other option, the brand new machine could have looked more attractive to you. Its relative value would be higher.
Sometimes, the fair value can change dramatically. If you get an info that the new machine is going to get an upgrade and will be able to print $300, its fair value goes up significantly.
This means that fair value is not constant. It’s always the discounted value of all future cash flows that will be generated, however, the machine’s prospects can change. In this case, fair value also changes, either negatively or positively.
This brings us to the fluidity of fair value.
📈 Fair Value Is Fluid
Fair value is a range and the natural consequence of this is its fluidity within the range. However, the range itself is also mutable.
Let’s get back to our printing machine example. We found our purely quantitative value to be between $600 and $1,000.
We could adjust this upward and downward depending on our perceived value. If you don’t want to take a trip to the copy center, you may add some premium and come up with $1,100. If raw material cost decreases to $0.55, you will adjust the base to $550.
In this case, based on what’s available, your fair value range would be between $550 and $1,100.
However, the boundaries are also fluid and can be adjusted by new events. For instance, if the only copy center in your town announces that it’s closing, base and ceiling could spike and new range could be between $850 and $1400.
It’s always fluid.
The challenge is finding out how the changing factors affect the fair value by changing the future prospects of our money printing machine.
This is why thinking about the concept is way more valuable than the wholesale adoption of formulas and cheat sheets.
🤔 Final Thoughts
Fair value is one of the central concepts of investing.
Luckily people have an inner compass for finding fair value in their ordinary life.
However, we lack that compass when it comes to investing.
Fair value is nowhere as solid in markets as it’s in the grocery store, but it’s equally real.
In one sentence, fair value is the current value of a benefit expected from a good or service based on the cost structure and the price of available alternatives. In case of bread, it’s the value attached to eating it; in case of businesses, it’s the current value of the all cash flows it’s going to generate in the future.
It’s fluid. It is affected by the events. It’s hard to calculate.
This is what we talk about when we say “fair value”.
To succeed in investing, you should always keep thinking about it.
In the next issue of this course, we will talk about calculating a fair value for stocks.
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The fundamental value of a stock is determined by institutional investors. You're right it's a range (a dynamic one). Ratios like P/E and P/B are useless here. They're different for different industries and even for different stocks within the same industry. The key is to be able to find accumulation patterns in stock charts. Then you have the fundamental value of a stock.