The concept of ‘value’ is core to investing.

At one level, it’s a relatively straightforward idea, and one we intuitively understand. As investors, we are, essentially, trying to buy assets for less than what they are “really” worth. For us, the value is captured when the wider market recognises and corrects the mispricing.

But there’s also value in something that is (somehow) perfectly priced. Not because there’s any fundamental driver of ‘alpha’, as the traders say, but because it will preserve our purchasing power over time.

Even an asset that is overpriced can have at least some value. It may represent an unattractive return, or even a loss, but as long as it’s not zero it’s worth something.

It’s our job as investors to try and figure out what that something is, and there’s a wide array of theory, formulas, metrics and models to help us. There are limitations, of course, but so long as you’re mindful of them, and don’t mistake the map for the territory, so to speak, the analytical approach can yield good advantage.

Just bear in mind that there is no objective truth when it comes to value.

Not because we can’t possibly hope to accurately predict the future, and therefore know what to input into our formulas (though that’s most certainly true). But because value is an entirely subjective.

Even if two people have the exact same expectations for a company’s long term cash flows — right down to the cent — the present value of all those earnings will depend on the rate of return each person desires. If you feel it appropriate to demand a 10% annual return, but I’m happy with an 8% return, neither of us is wrong per se — it’s a personal choice, and one that depends on our own unique set of circumstances. The point is that we’ll both have a different, yet equally legitimate, concept of value.

None of this is to try and make an already difficult endeavour — ie. the rational valuation of stocks — seem entirely futile. It’s not. Rather, by thinking more deeply about value, from a first principles perspective, we’re better placed to properly identify it in the first place.

Before we even start to think about whether a company’s shares represent value, we have to first ask what value the company itself is delivering to its customers. Regardless of the industry or business model, if an enterprise can’t provide enough value to enough people to at least cover its costs, the entire thing will inevitably fail.

It seems super obvious, but it’s the only rational starting point for any analysis. If your insights here are flawed, no amount of mathematical sophistication is going to help.

Before you break out the spreadsheet, first ask yourself these questions:

  • What problem does the company solve?
  • What advantage does the company have over others in solving this problem, and how easily can that be sustained?
  • Is there any evidence for customer value creation? (eg. growing sales, increased pricing, greater market share etc)

You shouldn’t base an investment on these questions alone, but if you can’t answer them favourably, and with conviction, there’s no point in going further. 

Start with the basics, and then zoom in.

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