Saturday 1 November 2008

Value assessment does not rely on precision

Investing is the intention to seek a required rate of return (RR) relative to risk, based on an assessement of value.

The deployment of capital in the absence of assessment of value is called speculation.

Value investing can be defined as buying a share at a price lower than its calculated value. Only investors who have the ability to calculate value can call themselves "value investors"

The very factor on which investing is based, namely value, is little understood, and therefore nearly always ignored.

Warren Buffett once said: "I'd rather be approximately right than precisely wrong."

Stock valuation is subjective in that it requires a judgement of the sustainability of past profitability and is therefore far from being an exact science. Like price, value will not increase in neat, even increments year after year, but will vary with the changing fortunes of the business.

An assessment of value is determined by making forward assumptions of a business's performance based on its historical performance. Depending on the current outlook for the business and its future prospects, the adopted performance criteria (APC) may differ from thsoe that past performance indicates. One also needs to make an assessment of the RR to compensate for many factors. The adopted assumptions are then used to calculate the value, the preciseness of which is not as important as being, as Buffett suggests, "approximately right."

As essential as valuation is in determining the margin of safety between value and price, other factors need to be considered when deciding whether a stock should be bought or sold.

The argument that value is misleading because it infers precision is as foolish as suggesting that real estate valuations are a waste of time because they too imply precision.

A recommendation may be correct, but unless it is accompanied by evidence of value, it can be considered only an unjustified expression of opinion.

Investing in stocks is not about buying scrip that will go up and down in price, but about investing long term in a sound business that represents good value at its present price.

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