I’m sure that most people familiar with value investing are aware of the idea that investment in stocks should be thought of as an investment in a business. Ben Graham said in “The Intelligent Investor,” “Investing is most intelligent when it is most businesslike.” Well, this is just one obvious implication of the first axiom! Another well known idea central to value investing theory is the idea that long term stock prices will eventually converge with the intrinsic value of the business. Because a stock is ownership in a business, purchasing it at an undervalued price guarantees you above market returns via the cash flows earned by the business. Since people will put their money into investments guaranteeing the highest possible return, the stock price of the business will be driven up until the rate of return from cash flows equals the market rate of return (perhaps the fact that rates of return converge to the mean should be listed as another axiom?).

Now what principles can be derived from the second axiom? Well, if you have a given interest rate (the time premium referred to in the last post), you can tell exactly what a certain cash flow is worth to you today. If your time premium is 5% per year, then $1 given to you next year is worth $1*(1-.05)=$.95. The formula for present value of a cash flow is: PV=FV(1-d)^n. Where ‘PV’ is the present value, ‘FV’ is the future value, ‘d’ is the discount rate percentage (time premium) expressed as a decimal, and ‘n’ is the number of periods (note that the length of a period corresponds to the time implicit in the discount rate, ie. if the discount rate is a percentage per year, then ‘n’ is expressed in years). Now that we can determine the present value of a future cash flow, we can add up the present value of each year’s cash flow to determine the business’s value!

Note: I simplified the discount rate by referring to it as a “time premium” when in reality it is both a premium paid for time as well as a premium paid for risk.

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