Fundamental valuation of an investment

The formula for valuing all assets that are purchased for financial gain has been unchanged since it was first laid out by a very smart man in about 600 B.C .

The oracle was Aesop and his enduring, though somewhat incomplete investment insight was "a bird in hand is worth two in the bush." To flesh out this principle, you must answer 3 questions. How certain are you that there'r indeed birds in the bush? When will they emerge and how many will there be? What is the risk-free interest rate (which we consider to be the long term U.S.bonds.)? If you can answer these 3 questions, you will know the maximum value of the bush - and the max number of birds you now possess that should be offered for it. Don't think in terms of birds, think in dollars.

Aesop's investment axiom, thus expanded and converted to dollars, is immutable. It applies to outlays for farms, oil royalties, bonds, stocks, lottery tickets, and manufacturing plants. And neither the invention of the steam engine, the harnessing of electricity nor the creation of the automobile change the formula one iota - nor will the internet. Just insert the correct and logical numbers, and you can rank the atttractiveness of all possible uses of capital throughout the universe.

Common yardsticks such as dividend yield, the price to earnings ratio or to book value, and even growth rate have nothing to do with the valuation except to the extent they provide clues to the amount and the timing of the cash flows into and out of the business. Indeed growth can destroy value if it requires cash inputs in the early years of a project or an enterprise that exceed the discounted value of the cash that those assets can generate in the later years. Market commentators and investment managers will glibly refer to "growth" and "value" styles as contrasting approaches to investment are clearly displaying their ignorance, not their sophistication. Growth is simply a component - usually a plus, sometimes a minus - in the value equation.

Determining the interest rate is the easiest, though plugging in the numbers for the earlier variables is a difficult task. Using precise numbers is, in fact, foolish; working with a range of possibilities is the better approach.

Usually, the range can be so wide that no useful conclusion can be reached. Occassionally, though, even very conservative estimates about the future emergence of birds reveal that the price quoted is startling low in relation to value. To be sure, an investor needs some general understanding of business economics as well as the ability to think independently to reach a well-founded positive conclusion. But the investor does not need brillance or binding insights.

At the other extreme, there'r many times when the most brillant of investors can't muster a conviction about the birds to emerge, not even when a broad range of estimates is deployed. This kind of uncertainty frequently occurs when new businesses and rapidly changing industries are under examination or pressure. In cases of this sort, any capital commitment must be labelled as speculative.