Everything else we invest in must logically be anchored to the risk-free rate. In business, if you invest in $100 in inventory, you should have the expectation of selling it at a high enough margin that, when everything including taxes are accounted for, earns you more than the riskfree rate. Otherwise, why bother?
Let's trot out the good old lemonade stand as a concrete example. Its business model: buy lemons, sell lemonades. Its costs (a.k.a. investments): raw lemons, a lemonade stand, hourly wage for your workers, etc. The goal is to make more money selling lemonade than it costs to set up and run the enterprise. At the end of the year, you tally everything up, all the cash that was spent and all the cash that was made. If you spent $1,000 and made $1,200, that is a healthy 20% return on your investment.
But what is this business worth? What is your lemonade stand worth if you want to sell it?
The intrinsic value of anything is the sum total of the cash you can extract from it over its lifespan discounted by the risk you're taking. It's a simple definition but it is basically impossible to pin down an exact number due to the subjective and fluctuating variables in the formula2 . Even the value of a risk-free U.S. Government Bond is unknown because interest rates fluctuate continually3 . So, the first thing one should admit upfront is that there is no such thing as an accurate intrinsic value. What we should do instead is make conservative assumptions, acknowledging the inherent uncertainty of the future, and arrive at a rough range that approximates an intrinsic value.
So. Back to the lemonade stand. We know the business earned $200 last year in net profits. The next thing we need to know is, is that profit level sustainable? Is it in a competitive neighborhood with entrepreneurial kids, or is it in a retirement community with little risk of competition? Is its proprietor interested in continuing to manage the stand or do you have to find someone else to run it who may not know the business as well? How about the cost of lemons? Wasn't there a shortage recently due to bad weather? How about repairs to the stand, which has suffered some wear and tear? How about the fact that a controversial study blamed lemonade for increasing the risk of heart disease? Will that dampen demand?
Even after just a cursory bit of thinking on the matter, it's probably pretty clear that there's quite a bit of risk. Lemonade is, after all, a commodity – widely available and undifferentiated. Just because the business earned $200 last year is no guarantee it will earn the same or more next year. Thus, a conservative investor would probably not pay very much for the business4 .
As simplistic as this sounds, that's basically business valuation in a nutshell. Figure out how it makes money, figure how much it could make in the future, and then add it up and discount it. To contrast the instability (and thus low value) of a commodity business, consider the worth of a business like Disney. Not only do they own one of the most iconic brands associated with happy childhood memories, they also own ESPN and Marvel and a litany of other cultural mainstays deeply ingrained in global culture. Billions of people will always consume their products and feel good and pass on their stories to their kids who will in turn pass it on to their kids. Properly managed, Disney's cash flows will be prodigious and predictable and unassailable. They are worth many multiples of their annual profits because you can be near-certain they will earn it year after year after year.
***
Why does this matter in the stock market? Because a stock is a fractional interest in a business. A shareholder has a claim on the profits. The more shares you own, the bigger the claim. Logically, it follows that if you've analyzed a company and purchased its shares at a valuation you deem attractive, you'd salivate at an opportunity to lay a bigger claim at a cheaper price.
But, you might argue, such claims to profits are merely theoretical. There's no way to take those profits and, say, buy a house. You depend on selling shares to monetize your investment, and thus, by proxy, depend on what others will pay for your share, i.e. the whims and volatility of Mr. Market. So, the market’s daily movements matter, right?
To which I'd respond, yes, but only if your need for said monetization is immediate or shortterm. In which case, you shouldn't be investing in stocks at all. In finance, there is a concept called duration. The longer the duration of a security, the more prone it is to price swings because the far-future is more unpredictable than the near-future. Equity is the longest duration security of them all, one with essentially limitless duration, and thus, your timeframe, your obligations that you need to meet with the cash, should match up with what you're investing in.
Over time, as I've often quoted Benjamin Graham, the market is a reliable weighing machine. Businesses that are chronically undervalued on the market implement policies to return capital to shareholders via dividends or share buybacks or get sold for big premiums to private buyers. Mismanaged businesses attract activist investors who oust the board and implement radical changes in efforts to preserve or extract value. The bottom-line is, while there are many ways to skin the cat, prices that are out of sync with value almost always, inevitably, converge.
“If you know the enemy and know yourself, you need not fear the result of a hundred battles.”______________________
–Sun Tzu
1 But unfortunately, you'll earn, in today's environment, a miserly two pennies a year. And that's only if you promise to lend it for 10 years.
2 E.g. What is the appropriate discount rate? What are the expected cash flows each year?
3 E.g. Who would buy your bond for the amount you paid if the coupon on that bond is less than the coupon on a newly issued bond?
4 Unless the investor owns, say, a national chain of lemonade stands that he/she can integrate it into, shaving off costs via economies of scale
