The Little Book of Valuation, Updated Edition

Chapter OneValue—More than a Number!: Understanding the Terrain

OSCAR WILDE DEFINED A CYNIC AS ONE WHO “knows the price of everything and the value of nothing.” The same can be said of many investors who regard investing as a game and define winning as staying ahead of the pack.

A postulate of sound investing is that an investor does not pay more for an asset than it is worth. If you accept this proposition, it follows that you must at least try to value whatever you are buying before buying it. I know there are those who argue that value is in the eyes of the beholder and that any price can be justified if there are other investors who perceive an investment to be worth that amount. That is patently absurd. Perceptions may be all that matter when the asset is a painting or a sculpture, but you buy financial assets for the cash flows that you expect to receive. The price of a stock cannot be justified by merely using the argument that there will be other investors around who will pay a higher price in the future. That is the equivalent of playing an expensive game of musical chairs, and the question becomes: Where will you be when the music stops?

Two Approaches to Valuation

Ultimately, there are dozens of valuation models but only two valuation approaches: intrinsic and relative. In intrinsic valuation, we begin with a simple proposition: the intrinsic value of an asset is ...