Value investing discussions invariably begin by noting that intrinsic worth is the discounted cash flows of an asset, without pausing to define the asset.
The process is relatively straightforward for assets such as government bonds, a family-owned pizza shop, or a gold mine. It is trickier for common stock.
In the case of common stock, the asset is either the company or the specific stock. The difference concerns the control value associated with owning 100 percent of the stock compared to a single share or other minority interest.
A medium-sized company with 1 million shares outstanding might spin off $100 million in excess cash this year. Each share is theoretically entitled to $100. That could be the basis of a valuation of ownership of that company for this year. But takeover investors interested in buying the entire company will often bid more than $100 million to buy it. In valuation disputes brought by minority shareholders, courts will often add an analogous premium.
Markets tend to price individual shares as if they are minority shares. To value a share of stock, therefore, requires valuing both the business as:
- a whole and
- the individual share.
The result might be that the company valuation is $100 while the price is $90. That does not automatically mean the stock is underpriced and therefore a value investment option. A build-in discount arises in market trading.
Therefore a bigger margin of safety is warranted. This is one of many factors that drove Graham’s margin of safety principle. On the other hand, a well-developed takeover market emerged in the decades since Graham pioneered his method. Take over investors are willing to pay high market premiums and thus return to individual holders a sizeable control premium.
Some value investors treat takeover prospects as catalysts to realize value from investment.
For nonprofessional investors, however, betting on takeovers is even more difficult than the general habit of seeking franchise businesses at margin-of-safety prices.
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