Saturday, 18 February 2012

The essential point in security analysis is to establish that the value is adequate

Businesses, unlike debt instruments, do not have contractual cash flows.  As a result, they cannot be as precisely valued as bonds.  

Benjamin Graham knew how hard it is to pinpoint the value of businesses and thus of equity securities that represent fractional ownership of those businesses.  In Security Analysis he and Dodd discussed the concept of a range of value.

'The essential point is that security analysis does not seek to determine exactly what is the intrinsic value of a given security.  It needs only to establish that the value is adequate - e.g., to protect a bond or to justify a stock purchase - or else that the value is considerably higher or considerably lower than the market price.  For such purposes an indefinite and approximate measure of the intrinsic value may be sufficient.'

Indeed, Graham frequently performed a calculation known as net working capital per share, a back-of-the-envelope estimate of a company's liquidation value. His use of this rough approximation was a tacit  admission that he was often unable to ascertain a company's value more precisely.

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