If you’re in the market to make money, there are really only 3 reasons to buy a stock.

Reason #1: The Stock is Currently Undervalued: “The stock price is currently below the value of the business it represents.”

Defining ‘value’ can be a tricky thing. Intro to Finance 101 at any school in America teaches the value of any asset is equal to the sum of the present value of its future cash flows. Experienced market traders might quip that the value of something is whatever someone else will pay for it.

In the traditional sense of value investing, value is the price at which a company’s stock should trade. To discover value, an analyst tries to consider all available financial information, prospects for both macroeconomic and industry-specific growth, confidence in the management team, and countless other variables, weight each variable accordingly, and arrive at a number that represents the worth of the business in question. If the calculated worth is greater than the price at which a company’s stock price indicates, then the stock is ‘undervalued’. A worth below the indicated price, ‘overvalued’. Not exactly earth-shattering.

Unfortunately, calculating intrinsic value has a few glaring issues in practice.

First, there are countless variables to account for and limited information. Publicly traded companies are required to file detailed financial statements with the SEC, but even those can leave analysts with more questions than answers And analysts don’t just have to worry about business-specific information – external factors like economic growth trends, regulatory dynamics, and interest rates all impact the worth of a company. What’s more, the goal is to calculate what cash flows will be in the future. As if finding a value for all those variables wasn’t hard enough, now the analyst has to predict what each variable’s value will be.

That’s the second problem with valuation: we have limited foresight. For the sake of argument, let’s assume an analyst can reasonably estimate 5 years into the future for a given business. For 5 years ahead, he can put a number to all the variables and calculate cash flows. But anything beyond 5 years – the Horizon of Reasonable Predictability (HRP) – can’t be predicted with any degree of certainty. Still, value is supposed to include ALL of the future cash flows, not just those over the next 5 years. The analyst has to make predictions about something beyond the HRP, knowing full well that he’s just guessing. In the end, the most reasonable thing to do is choose the mid-point of a range of likely outcomes.

So perhaps the biggest problem with valuation is that no one actually knows what the correct value of anything is. Not with certainty, anyway. It’s entirely subjective to the estimates and opinions of the one calculating it. We could ask 1,000 people, all of them extremely qualified, to value the same business, and we’d get 1,000 different answers. At best, an average of those 1,000 answers might represent something close to a company’s true value. But here’s one more dynamic to consider: if you asked them all again a year later, the answers would be different. Valuation is a point-in-time calculation. As time progresses, uncertain things that were previously beyond the HRP become certain, and value changes.

By now I hope it’s clear that even though the precise worth of a business exists, calculating it is virtually impossible. So how is it that legends like Benjamin Graham were able to generate superior investing results through a value investing approach? Because their goal wasn’t to precisely calculate the worth of a business. It was to buy undervalued stocks for the purpose of making money. For that they just needed a general idea of value. When the stock price differed significantly from that general idea, they took advantage by buying or selling, then waited until prices agreed.

On balance, it worked out well for them. Incredibly well. But before you rush off to become the next great investor, there’s a catch: it doesn’t always work. I’m not just saying that valuation is tricky, I’m saying the strategy itself has a flaw. That is, undervalued stocks don’t always go up. So even if you were the greatest analyst in the history of world, if you knew the value of a multi-billion dollar company to the last penny, none of it matters if the stock price doesn’t move towards value. There’s no rule saying it has to. Now, that’s not to say a value-based strategy can’t work. We saw it work for Graham, remember? Over time, stock prices do tend to move towards value. It’s just that over time, value changes!

If value stays constant or rises over time, the job is relatively easy. Buy when the stock is underpriced, sell when it’s overpriced. Retire.

But what if value is trending lower? We can buy when the stock is undervalued, and if prices quickly move towards value, we still profit. But if price takes too long to correct, or if we hold the position for too long, the new value ends up below where we bought it.

If we choose not to sell and take the loss at that point, it’s either because we’re hoping the value will trend up in the future, or alternatively, betting the stock price will become overvalued. The former is unpredictable by its very definition (value already includes everything that can be reasonably predicted, and the change in value will be determined by something beyond the HRP), and the latter is the antithesis of a value investing strategy.

So in summary, Reason #1 for owning a stock has a proven track record of success (see Graham et al), but depends upon an accurate estimation of value and a stock price that converges towards that value quickly.

Check back next week for the Part 2!

Nothing in this post or on this site is intended as a recommendation or an offer to buy or sell securities. Posts on Means to a Trend are meant for informational and entertainment purposes only. I or my affiliates may hold positions in securities mentioned in posts. Please see my Disclosure page for more information.