Author: Mrunal Shah
All successful investment involves trying to get into something where it’s worth more than you’re paying.
Even the world's greatest business is not a good investment if the price is too high.
If you have an opinion about the level of prices, it should be an opinion based upon your concept of the values of securities in relation to price, rather than on any prophecy or expectation of changes or of the continuance of a given moment.
Heard about these things from one or the other great investor regardless of their nationality, language they speak or business they are into? Ever got curious about that one thing that makes an investment successful or which helps those investors in turning into billionaires?
Let us explore this curiosity together by understanding the holy grail of investing, i.e., ‘VALUE’. Investing is all about Valuing the business and buying it below its intrinsic value.
Sounds too complex? I have heard that stories have the power to make things easy. Let’s try to ease this complexity with a story.
Once upon a time, there was a wealthy businessman named Kosai Lama from Yamato, Japan. His business knowledge and tactics were highly renowned throughout the region. One of his many life-changing and thought-provoking teachings is from the test he gave to his two sons, Lao Tzu and Lin Tzu.
The narrative begins in the Sengoku era, during the late 14th and early 15th centuries. Lao and Lin had just graduated from high school and were eager to take over the family business. However the leader of the family business was to be decided. For deciding it on fair grounds, Kosai Lama had set a test, the winner of which would be announced as the business’ leader and given the control.
The family operated multiple businesses. However, farming provided the majority of their family's revenue. Kosai Lama possessed hundreds of farms and thousands of livestock. The test for both of his sons was to execute a legitimate deal for purchasing a healthy cow which can be used for productive purposes. Lao and Lin were both handed an equal amount of Japanese MON to buy the cow. The only condition was that they start buying the cattle exactly on completion of 2 months.
Lin had a joyous nature and loved to travel. Being the son of a wealthy businessman he had no constraints to travel wherever in the world. He went on a trip with his friends to celebrate the completion of his graduation, as most teenagers of this generation do. He assumed his father had allowed him two months to enjoy his trip before allowing him to purchase the cow.
On the other hand, Lao was an introvert, loved to read books and possessed a curious mind. He was mature and had sincerity towards life. He contemplated his father’s condition for buying the cow and wondered why he had to wait for a couple of months to just purchase a cow which can be done any day? With all sorts of questions juggling in his mind, Lao went to the central library. There he eavesdropped on some individuals discussing and wondering about the fluctuation in prices of grains based on seasons. He heard one of them talking about the movement in prices due to the anticipation of a good or bad season in the future. Listening to this, he realised that even the prices of cows must fluctuate. In order to understand the trend, he invested his time in understanding the market about cows.
He started with visiting sheds for observing the daily routine of cows for two weeks. In those two weeks he observed the number of cows in the city, type and quantity of food they were given, the intervals after which food was required, frequency of illness, litres of milk each cow gave and the amount of work they did in a day and much more.
He spent the next two weeks researching fluctuations in milk pricing, as milk would be the source of income after acquiring the cow. After those two weeks, Lao realized that the biggest expense in keeping a cattle is the feed fed to it so he visited the grains and hay market to learn about their prices in order to estimate food costs.
Before two days of the deadline for purchasing the cow, Lao had collected all the information regarding cows. He assessed all of the expenses he would have to incur after purchasing the cow. He was able to predict the daily cost since he had learned everything there was to know about cows. He was aware that the cow's typical life expectancy was 15-18 years, during which it might work effectively and provide a return on his investment.
The D-Day finally arrived and the father took both of his sons to the animal traders market. They were warmly greeted by the animal trader. Kosai Lama introduced both his sons to the trader and conveyed their desire to buy cows from him.
Lin initiated the conversation with the trader by inquiring about the price of the cow. The merchant indicated that there are numerous cows of all ages, with prices varying according to age. Lin picked a beautiful white cow and inquired about the cost. The merchant said that it was ten years old and that its price was 700 MON. The white cow was so beautiful and in such high demand that the seller refused to reduce the price, and Lin paid the trader's asking amount.
When Lao was given a chance, he chose a fit black cow and inquired for its age, type and price. The trader informed him that it was a 10 year old cow of Indian subcontinent and was priced at 1300 MON. Lao instantly started calculating in his mind the value of the cow. After giving the calculations a thought, he countered the offer and said that 550 MON is the maximum price that he can pay. His father was surprised by the figure he gave to buy the cow as he had a similar figure in mind after doing his own calculations. Lao was not ready to pay the price above the true value or the intrinsic value of that cow. After rigorous bargaining, the trader accepted his demand and sold the cow for 600 MON. Upon returning home, the father asked Lao how he came to this price. Lao explained the calculations that he did to arrive at the exact price. Impressed by the answer, Kosai Lama immediately announced that his successor would be Lao Tzu.
The story was pretty interesting indeed. I know the reason you are engaged till now is the curiosity to know how Lao arrived at his offer price. Don’t worry; I would not keep you hanging in there for long.
Lao estimated two things: the income he would receive from having the cow for five years (since the cow was ten years old and had a life expectancy of fifteen years) and the expenditures he would incur in keeping the animal during the same time period. But do you believe this is it? Wait for the most essential factor, cost of capital. The cost of capital can either be an opportunity cost of the funds possessed or the actual rate at which the funds are borrowed. The opportunity cost of the capital is the return obtained when the funds are invested elsewhere.
Theoretically it sounds perfect, doesn’t it? But how do we determine the opportunity cost of capital? In general, an average fixed deposit bank interest rate is regarded as the cost of capital since it represents the minimal interest that we would expect after investing. Lao calculated it to be 8%. He figured that the revenue from the cow is 600 MON each year for the next five years, and the cost for the same period is 300 MON. In this case, he would make 300 MON each year. So, after discounting it at 8% using the time value of money concept, he would obtain 1200 MON. This is the most Lao should spend for the cow. Now, Lao would not want the profit to be the bare minimum, i.e., 8%, so he would charge a profit percentage over and above what is the bare minimum. As a result, the ultimate sum he was willing to pay is 600 MON, half the amount he would have earned in the coming five years after deducting all the expenses including the opportunity cost of capital.
VALUE
Value, a five-letter term that is considered the holy grail of investment, has different interpretations. Some confuse value with price. On the other hand, others express value as a qualitative feature such as the perceived value of a company’s product by the consumers, the management's vision for the company, any technical competitive edge that the company has, and so on.
For investing successfully you should buy the company below its intrinsic value but finding the true value or the intrinsic value of a company is not easy to calculate because it has endless possibilities and complexity. The complexity involved is not in calculating it quantitatively but in estimating the future profits. Make sure to do a thorough research so that chances of overestimation are less. Always be a bit more conservative as was Lao who after getting 1200 MON as the intrinsic value asked for the cow at half the price so that in case of any overestimation, there is a cover.
Don’t worry if all this seems difficult, contact us at axanoun@gmail.com to get all your doubts cleared. The experts at the organisation would be happy to help.