We agree with the value masters – the value of a business is what an outside investor (who knows the business) will pay for the company. But because the value is only known when a business sale occurs, this is not always a practical way to value securities in an ongoing fashion.

Remember, we don’t put any credence in how the market values businesses. Because we know it has a wild tendency to overvalue them (during periods of euphoria – perhaps like now) and undervalue them during periods of pessimism (like in 2014 and 2015 in emerging markets and 2008 and 2009 in the United States).

Morningstar has an excellent and practical approach to stock valuation. An approach learned from Warren Buffett.

Morningstar sets the fair value to a company based on its future earnings. Because investors are willing to pay more for earnings today than they are for earnings in the future, earnings must be discounted by the cost a company incurs to create the earnings, which we call its cost of capital.

A simpler approach to setting fair value, then, requires an estimation of a company’s:

• Future Earnings
• Cost of capital

The value of the company will change if either of these things change. But it will also change if both estimations were exactly right! If estimates are right the price and value of the company will rise over time, generally about 9% per year at fair value.

Future earnings depend on a company’s ability to deliver. When a company does better than expected, prices rise. When a company does worse than expected, prices fall. The trick is to figure out whether the rise or fall in earnings is temporary or permanent.

If the earnings impairment is temporary it is a short-term blip which means falling earnings are an opportunity to buy an undervalued stock. But if the change is permanent, the company’s value is also impacted.

Estimating the cost of capital is simpler (as long as we assume rates will be somewhat stable). Cost of capital is simply cost of equity and cost of debt. If a company has no debt then its cost of capital is 100% its cost of equity.

The cost of equity depends on the risk of a company’s cash flows. If the cash flows are easy to predict the cost of equity is low. If the cash flows are difficult to predict the cost of equity is high.

For example, an established consumer goods company with established and predictable cash flows will have a low cost of equity. Morningstar may assign it a cost of equity of 7.5%.

On the other hand, a new biotech company with highly uncertain cash flows is considered risky and may be assigned a cost of equity of 13.5%.

This means that if Morningstar gets everything right you would make 7.5% per year in the stodgy company and 13.5% in the riskier company.

But from the perspective of future interest rates cost of capital is more difficult to estimate. If interest rates go up, for instance, this can affect both earnings and the cost of capital. Morningstar assumes changes in interest rates will be slow and gradual, and, in general, companies can increase prices as inflation rises.

Some investment managers refuse to make this assumption. These managers are more conservative in valuing companies and will lag during periods of euphoria (like now) with the hopes of doing better when there is an inevitable downturn, but capitalizing on the opportunity to buy companies at lower prices.

We agree that Morningstar’s valuation model is imperfect. But because we don’t have a crystal ball we cannot know future interest rates. And while we believe they will be higher, we believe they will rise in a slow and orderly fashion. This is our base case.

This is perhaps the greatest risk we take as investors. The future is unknowable. But we believe the world will continue to turn and that by honoring our risk budgets (every client gets an allocation to risk based on their risk score) and by looking globally for opportunities that there is always something to do.

Which means we will continue to act as enterprising investors company by company.

Enterprising investors seek to buy shares of companies selling below their fair value. This is what we do in our Great Businesses stock portfolios and our carefully selected manager/ partners do in the portfolios they manage.

For more on this topic, read this.