This is a topic I have wanted to write about for a while yet never quite found the right moment for. Then, cryptocurrency entered mainstream ‘awareness’ and I started thinking about how one would price non-productive, cash-less assets if someone put a gun to your head and did not accept the rough (but probably fairly close to the truth) estimate of zero. It quickly became apparent, that extending the value framework to cash-flow-free assets required thinking about the very core of value and why/how it works. That is what this very compact post is about. Though I am likely to revisit this topic in more detail in the future, I hope that his snippet will prove worth the read nonetheless.
In value investing, intrinsic price (often called value) of an asset (or a collection thereof, e.g. a firm) is determined by discounting the sum of all future generated cash flows. The cash flow part is fairly self-explanatory but tricky in a couple of ways, such as cash flows being unequally distributed over time (‘lumpy’), inflation, the fundamental uncertainty of their occurrence and magnitude in the first place and so on. The process of discounting is supposed to account for these hurdles in pricing the nominal cash flows but is affected also by the current ‘risk-free rate of return’ which is strongly determined (and proxied) by interest rates (via treasury bills and the like).
I personally have a few problems with the notions of risk and return that prevail in finance today but the underlying concept of ‘cheaper’ returns (in other words, greater risk-adjusted returns) in a competitive market warranting, ceteris paribus, less nominal discounting (up until it is priced in line with its alternatives after adjustment for risk and asset characteristic preferences) is, of course, sound [basically, people want to maximize their risk-adjusted, preference-weighted returns and compare the choices available to them and because they compete, better deals tend to get arbitraged away].
What is crucial to understand is that value investing is, ultimately, a pricing framework. Of course it also values assets but it does so in order to ultimately help price them! It appears to me very dangerous to forget the purpose of the value philosophy and succumb to moralistic notions of value being the superior metric of measurement just because the investor happens to believe so or has been told so by a supposed authority. An investor who hopes to properly serve his function as a capital delegator (others might prefer the term capital allocator which I think is taking too much credit in the grand scheme) ought to think like a craftsman with his models of pricing and capital as tools and raw material, respectively. If the hammer does not effectively accomplish the task at hand then considerations should be made both as to whether there is need for a different tool and as to whether the endeavor is worthwhile as such.
Now, of course, thought should also be given to the reason why a certain tool is particularly well- or ill-suited for this task (say, of pricing). How come a fundamental/value approach is an excellent tool-set for the long-term pricing of cash-flow producing assets? In this case, it is because the value philosophy better recognizes the most important causal factor driving price trends in the long-term: the asset’s capacity to generate profit (which of course comes from cash flow).
But what is profit? Long-term sustainable Profit is the result of cost-efficient monetization of the creation of utility for customers!
With this in mind, it should become clear why profits drive long-term prices (but I will elaborate nonetheless because I enjoy reading my own opinion back and nodding in agreement).
The key to seeing the fundamental implications of a utility-based view of profit lies in understanding utility and why humans (and organisms in general) pursue it over time. Quite simply, it is because of natural selection! Organisms that do not pursue behavior that seeks to maximize utility tend to go extinct and/or do not reproduce very much. Behavior that maximizes utility is behavior that tends to maximize reproductive fitness and vice-versa. So over time, the number of agents that are utility-maximizing as a fraction of all agents asymptotically approaches 1 (i.e. they dominate).
Put yet another way, the sustainability (i.e. the characteristic of something to stick around and propagate over time) of a behavior is intimately linked to the sustainability of the agent that executes the behavior. For a behavior to be long-term, it needs to stick around (be sustainable).
So, what do all agents that influence prices over time have in common (because they have to in order to be able to affect prices)? They are able to buy or sell. To be able to buy and/or sell, an agent needs to be active (that is be alive/functional – which of course implies having been born/existing). They also need to be able to effect such a transaction – they need assets that are accepted in exchange (currency, equity, etc.; in our current system, anything that is monetizable).
And that is why natural selection matters in markets just as it does nearly everywhere else: Markets and transactions can only ever be dominated in the long-term by agents that are executing behavior that is seeking to maximize reproductive fitness (otherwise they would not be around/a significant factor). Since this behavior correlates with the pursuit of utility, customers who purchase goods and services tend to buy in ways that tend to maximize utility. This means that firms need to maximize cost-efficient creation of utility for customers in order to sustainably maximize long-term positive cash flows (profits!). Furthermore, it is these cash flows that fuel wages of workers and profits of owners. The money, in other words, which allows market participants to buy and sell! Therefore markets (including stock markets) are dominated, over time, by people seeking to maximize positive long-term cash-flow as they have both greater numbers and greater financial means to do so in the long-term. This applies to stock markets as well and hence to the price-trends of securities. Consequently, pricing frameworks that focus on the security-underlying firm’s long-term profitability prospects (such as value/fundamental investing) outperform frameworks that do not. This overall dynamic is also the reason why functioning capitalist systems inevitably are wealth- and utility creators.
I hope you found this bit of foundational theory intriguing
Tom
The Financial Flâneur 