A lot of what passes for security analysis looks a lot like the Greater Fool Theory. Investopedia defines the Greater Fool Theory as, “A theory that states it is possible to make money by buying securities, whether overvalued or not, and later selling them at a profit because there will always be someone (a bigger or greater fool) who is willing to pay the higher price.” This approach is as old as Wall Street, and, although a (very) few traders may consistently make money using this approach (without the benefit of an advantage such as high-frequency trading), the average person cannot.
Against this backdrop, Benjamin Graham came along and introduced a powerful new idea into the field of security analysis. The foundational idea was that when you buy a stock certificate you are buying a small piece of a real business. And if that is the case, a person ought to be able to come up with some idea of what the business is worth by studying the facts: the assets, earnings, dividends, future prospects, management, litigation, etc. This is what Graham called intrinsic value. Graham further recognized that because of the enormous volatility in the stock market, it would be possible from time to time to purchase shares of a given stock at a clear discount to what the underlying business was worth. This discount not only provided a rational basis for the expectancy of a decent return (or indecent, depending on the level of undervaluation), but also afforded the investor a cushion of safety against errors in judgement and analysis, and unforeseen future events.
Graham points out that it is not possible to determine the intrinsic value of a business with exact precision. It is usually a range of values. If you can establish this range, you can then determine if the stock is undervalued, overvalued, or fairly valued. This lack of precision need not be a problem, if you can buy the stock cheap enough. By analogy, Graham says it is quite possible to determine that a man is obese even if we do not know his precise weight, or that a woman is old enough to vote even if we do not know her precise age.
In Security Analysis (Sixth Edition) (pages 63-67), Graham gives two example of equities where he determines their intrinsic value.
Wright Aeronautical Corporation
Here is a profile of the company in 1922:
Share price: $8.00
Earnings: over $2.00
Cash per share: $8.00
Graham’s range of intrinsic value: $20 to $40
- Graham concluded the stock would be a bargain at $8.00 per share.
- The low end of the intrinsic value range is at most 10x earnings and as low as 6x earnings if we assume that the company had no debt. (At $20 per share you would only be paying $12 per share net of cash.)
- In no case would Graham estimate the value to be greater than 20x earnings ($40/$2).
Here is a profile of the company in 1928:
Share price: $280.00
Earnings: over $8.00 ($3.77 in 1927)
Net-asset value: $50.00
Graham’s range of intrinsic value in 1929: $50 to $80
- Graham thought that Wright Aeronautical might be worth as little as just over 6x its 1928 earnings. Graham may have looked at the earnings in 1927 and been unconvinced that the company could maintain earnings at the $8.00 level.
- In no case would Graham pay more than 10x (what appear to be peak) earnings of $8.00 per share.
- At $280.00 per share (35x 1928 earnings), Graham thought it was clear that Wright Aeronautical was overvalued.
Tomorrow I’ll take a look at J.J. Case Common and draw some conclusions for our use as contemporary value investors.