Value Investing Axioms

12 02 2010

In the simplest terms possible, value investing is buying $1.00 worth of current value for less an $1.00. That sounds wonderful, doesn’t it? Buying a $50 million business for $25 million, turning around and selling it for the full price. So what is the catch? First let’s start with the basics.

The axioms of value investing are:

1. A stock is a certificate of ownership in a business.

2. Money in your hand today is worth more than the promise of money tomorrow.

The first axiom needs little explanation while the second axiom is a restatement of the concept known as “the time value of money,” or what economist Ludwig von Mises refers to as “time preference.” In his treatise “Human Action,” von Mises explains why the time preference of money is an essential part of human nature:

“He who consumes a nonperishable good instead of postponing consumption for an indefinite later moment thereby reveals a higher valuation of present satisfaction as compared with later satisfaction. If he were not to prefer satisfaction in a nearer period of the future to that in a remoter period, he would never consume and so satisfy wants. He would always accumulate, he would never consume and enjoy. He would not consume today, but he would not consume tomorrow either, as the morrow would confront him with the same alternative. (pg. 484)”

Since man values present satisfaction higher than future satisfaction, the promise of future cash (which will provide the satisfaction) must have a premium built in. Hence interest rates. $1 today is worth $1.05 cents tomorrow. Or, going backwards, $1 of future cash is worth $.95 today. The valuation technique for businesses (which will be discussed in other posts) is ultimately built upon this principle.

As a side note, if one wants to create a theory applicable to real life, it’s necessary that the axioms of the theory are grounded in reality (and they definitely are for value investing).

EDIT: As I notice mistakes in my reasoning, I will announce that I’ve edited the post and any changes I’ve made. In the original post, I said that the second axiom was, “The value of a business is the value of its cash flows discounted to present value.” Actually, this is just a logical implication of the time value of money.

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