How to Value Stocks: Security Analysis

What Is This Crazy Lil' Thing Called Stock?

How to Value Stocks

By Randy Befumo

  • Rule 1: When we buy stock, we are buying businesses. (Publicly traded businesses, yes, but businesses all the same.)

Regular readers of the Motley Fool's news columns have been exposed to a fairly systematic approach to security analysis without the concomitant benefit of seeing it codified. Although the How to Value Stocks area in the Fool's School represents an earlier iteration, you should be warned that in many ways my thinking on how to go about valuing stocks has progressed well beyond that. So, in order to present a comprehensive overview, the five articles in this series will take us on a magical mystery tour on valuing publicly traded companies.

Beyond what I jokingly call the four dimensions of security analysis, there are some assumptions that you should be aware of before we plunge any deeper. The first is that very project we are engaging is how to value a publicly traded business. The words "stock" and "business" are interchangeable in my usage -- there is no methodology for valuing a stock that does not spring from the underlying business. "Investing in businesses makes the most sense when it is business-like," is our operative proverb.

The purpose of the public markets was never to create casino-style games or lottery tickets denominated in ticker symbols. From the very beginnings of the joint-stock corporation in Holland and England many centuries ago, the idea was to give entrepreneurs capital with which they could build businesses. In return for the capital, the investor would get the effective ownership of a portion of that company. In order to facilitate the needs of various individuals who invested, an independent, secondary market where they could buy and sell shares in these companies developed -- much like secondary markets for used cars, homes, art, and comic books were created.

If we assume that when you purchase a share of stock you are purchasing a business, a lot of other stuff falls neatly into place. This is very much a philosophical move -- if you have a certain epistemology, a certain hermeneutical structure becomes self-evident. Or, in plain English, if you have a set way of understanding how you understand, the way in which you will interpret information becomes fixed. Treating investing as a discipline in life requiring a philosophical approach and not some haphazard, random exercise, you have to come at it with some kind of pre-existing assumptions. Mine is simply that what we are dealing with is living, breathing, changing businesses -- not the myopic view that reduces things to abstract ticker symbols or squiggles on a chart.

It is this very assumption that makes me skeptical and willing to part company with almost every variety of mechanical model and price/volume driven approach to pinning down intrinsic value. In studying the actual practice of acquiring businesses, you very rarely find instances where the great businessmen of this century -- or any century -- demand to see a trend-line for a potential acquisition, or ask how purchasers of this business have fared historically. Besides, in a dizzying and confusing world of lightning-fast calculations and trillions of dollars seeking excess returns, any marginal value added by purely quantitative or technical analysis is added only in very short time frames and goes to the swiftest. Like most other undertakings, individuals with day jobs rarely rank among the swift.

Whether you are buying the whole business or just shares in the business, approaching the problem as if you were buying the entire enterprise enforces the same discipline any true acquirer would use. If you were to really go out and acquire a business, you would pay careful attention to the price paid; you would want to know the underlying quality of the business; you would concentrate your purchases in areas where you have the most knowledge; and you would consider how long you intended to own the business. Simply, you would care about valuation, quality, depth of knowledge, and time, my four dimensions of security analysis. We will focus on each one of these in turn in the rest of this series.

Next: The Price You Pay »