It is no doubt true that, when prompted, the maximum any given person would buy a dollar for is one dollar.
They know the intrinsic value… it is written on the front of the bill! Since they know the value they will logically refuse to overpay for it. And, naturally, buyers would jump at the opportunity to buy dollars for fifty cents and sellers would rush to sell dollars at one dollar and fifty cents. This makes perfect sense. By buying a dollar for fifty cents, you have just guaranteed a 100% return, and by selling a dollar at one dollar and fifty cents you have just experienced a 50% return. Both outcomes are highly favorable.
What if the value of dollar was not so easy to identify? What if after thorough analysis you determined the value of a dollar to be in the range of $0.90 to $1.10? At what prices would you be willing to buy and sell? In my opinion, this is the essence of investing. All the data necessary to reach a fairly well-informed conclusion about the value of an asset is generally available in the marketplace. However, the information is diffuse and it takes a lot of time and energy to perform an analysis robust enough to reach a logical valuation. Despite all the effort, the end valuation is based on the assumptions made by the analyst and is thus subjective. To combat the subjectivity and to adjust based on the analyst’s level of confidence, he or she will determine a likely valuation for an asset within a given range.
Having reasonably concluded the likely range of values an asset may be worth, the question becomes “at what price does the investor buy and sell?”. Using the example of the dollar above, if an analyst believes the dollar to be worth between $0.90 and $1.10, and the market is stating that the dollar is available for purchase for $1.05, do you buy it? Some may answer “yes” since the market price of the dollar is within the valuation range, albeit on the high side. Some may answer “no” because, while the market price is in the valuation range it is too high and does not provide a margin of safety in case we are wrong. Essentially, this is the stock market. The market consists of thousands of extremely bright individuals all trying to determine the intrinsic – subjective – value of assets. After adding thousands of opinions the market reaches a consensus and states the price is $1.00.
Students in finance programs at their universities are taught that since there are so many smart people all trying to undercover the underlying value of the assets in the market and since that each individual discovers new data and brings it to the market in order to profit then the market prices accurately reflect the assets underlying value. Therefore market prices are efficient and accurately reflect all available information. Market participants are thus made to believe prices are always rational and reflect the best information available. You, therefore, are not able to beat the market. Experience teaches us something different.
It was Benjamin Graham that gave us the idea of ‘Mr. Market’ which is essentially the collective consciousness of the market participants. Some days he is manic – he will buy at high prices. Some days he is depressive – he will sell at low prices. Experience teaches us that due to the involvement of humans in the markets; at times prices can become out of sync with their underlying values. It is then up to the analyst, who has performed detailed and diligent analysis ahead of time, to take advantage of Mr. Market’s mood swings.
To conclude our story, let’s refer back to the price of a subjective dollar. Today you identify a dollar to be worth between $0.90 and $1.10, with a mean value of $1.00. At that time, you also understand that the reasonable growth of the underlying value of the company is 10% per year. If the market is asking for a price of $1.05 to buy or sell, then a value investor would pass on this opportunity. Why? Because to buy at $1.05 and knowing the average value is $1.00 a value investor is provided with no margin of safety for being wrong. In one year you estimate the asset will be worth $0.99 to $1.21. Your return on investment is expected to be -5.7% to 15.2% with an average return of 4.8%. Is that good?
Well, for example, if an investor buys at $1.05 but it turns out the more accurate underlying value was $0.90 (low end of the range) and a growth rate only 5%, then it would take over three years for the underlying value of the business to catch up to the price you paid. The market would eventually reflect this information and you would be sitting with a losing investment for several years. What if you liked the business but the price was not right and you waited? Well when the information hits the market that the growth has slowed and the value has most likely decreased, people will sell as they discover their investment thesis was wrong. This selling causes an oversupply and the price drops. People are not always of even temperament and will sell simply because the price is dropping regardless of their valuation and analysis. In this example, let’s say the selling stops at $0.75 per share. An astute investor, after reviewing his or her assumptions, determines again the value is worth between $0.85 and $1.05. Being able to purchase at $0.75 provides a margin of safety and an infinitely more attractive entry price. The investor is then rewarded with the additional return when the price closes back to its underlying value and the future growth. Therefore, in one year the expected average value is to be $0.97, and the investor has an expected return of 29.5%.
In summation, an investor, when aware of the impact the price paid has on future expected returns, will demand a margin of safety. Other than the potential for higher future returns if an investor buys an asset for a price below its intrinsic value, they are also provided a margin of safety in case their investment thesis was wrong. Both temperament and a robust and thorough analysis are required to accurately determine when to buy or sell assets given the subjectivity in valuation work and the bi-polar behavior of market participants.
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