There is an investor's adage, "Price is what you pay; value is what you get." Thus, every share of stock has a value, here called the Model Value, which is independent of its current stock market price. At any point in time, the market price may be roughly equal, significantly higher, or significantly lower than the stock's Model Value. In cases where Model Value and market price diverge meaningfully, investment opportunities arise.
While some observers maintain that the market price is the single best estimate of value, we contend that over short periods of time, market prices are heavily influenced by the emotions of market participants. This may serve to push prices further away from its intrinsic value. Over sufficiently long periods of time-five years and longer-the stock market price tends to revert toward an accurately appraised intrinsic value as the underlying economic earnings will dominate the ephemeral hopes and fears of investors in explaining the value of the business.
The accuracy of the Model Value is subject to the quality of the inputs (as with most models in the social sciences, its efficacy can be described by GIGO, "garbage in-garbage out").
In estimating the fundamental variables to derive the Model Value, we adopt an interdisciplinary approach, trying not to exclude anything that can help us forecast normalized earnings, the projected growth rate, and the terminal multiple. In addition to current and historical financial statements, we assess industry economics, statistics and probability theory, politics and the regulatory environment, as well as psychology and consumer behavior.
In the absence of a user-specified input, the Derived Model Value assumes that an individual company's terminal valuation will revert toward a terminal "market" valuation. The basis for this rests on the economic theory that high returns on capital are not sustainable in the long run since high returns will attract competition. Conversely, low returns on capital will eventually cause competitors to exit or firms to restructure and return to economic profitability. However, due to the nature of certain industries or the company's positioning within the industry, some companies might be able to sustain their competitive advantage or some companies might never be able to improve their economic profitability. In such cases, the mean reversion assumption may not be warranted.
It can also be seen that the growth rate is but one component in determining the Derived Model Value, contrary to some notions of "value" and "growth" being mutually exclusive.
The rate used to discount future cash flows to their present value reflects not only the time value of money and inflation expectations, but also attempts to compensate for the inherent business and cash flow risk. We do not, however, define this risk as the past price volatility or attempt to gauge the future price volatility. The "risk premium" is meant to represent the uncertainty regarding the size and timing of the cash flows the business will produce, and the degree to which management can be counted on to channel the cash produced by the business to reward owners.
