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A Response to Brian
Valuation is of the mind.

by Jeff Fischer (TMFJeff)

ALEXANDRIA, VA (March 17, 1999) --
Dear Brian,

Thank you for your important letter. You essentially asked one of the oldest questions known to man (okay, second oldest): "How much does valuation matter?"

This difficult issue has been addressed from many angles in this column. My answer is brief and possibly infuriating. The answer to your question... (darken the computer screen and make these words echo in your head)... the answer to your question:

is in your mind.

That's not a cop-out response. I believe in fundamental valuation, but I also believe that analysis claiming to find "fair valuation" is nearly as random as my answer to your question. You ask, "Is fair valuation the discounted present value of the sum of all of the future cash flows a business can generate?"

I answer: more accurately, it's the discounted present value of the sum of all ESTIMATED future cash flows of a business for a reasonable amount of years ahead, but any hypothesized fair value we arrive at is greatly influenced in the moment by current interest rates, company growth rates, the economic scenario, and supply and demand in the stock market.

Mix all of that together and throw in market sentiment and momentum and you've got one outcome: a random outcome that you can't predict. Downward and upward momentum in the stock market alone can alter a company's valuation by 50% either way, as happened in 1973 to 1974, and perhaps as is happening in this bull market to the upside.

Valuation is so far from cut and dry that anyone who places a "fair value" on a stock should be labeled as IGNORANT. That's right: every full service broker and analyst placing "fair values" on stocks (or price targets) is ignorant. They're so ignorant that they can't see their own folly. You can be a brilliant analyst and place a fair value on Pfizer of $12 in 1985. A year later, you need to adjust your fair value. The value of a company rarely stops growing or deflating -- one or the other -- and is dependent not only on what a company might earn in the future, but on hundreds of external factors that move the stock market.

You would have sold Coca-Cola early this decade at 25 times earnings if you believed it exceeded fair value, and why wouldn't you believe so when using traditional valuation metrics? Of course, you would have been wrong. Why? Because your idea of fair valuation is SUBJECTIVE and it's YOUR OWN opinion. The market's idea is usually different and it's an unknown.

Fair valuation is an unknown that we try to shed light on by guessing a company's earnings potential and the market's tolerance for valuation multiples, which expands and contracts with the market's moods. You simply have to pay what you feel is reasonable, and if that's based partly on numbers and partly on hunches and on your own feelings, that's fine, because that's all anybody else is doing: making subjective judgments, some based on numbers, others not. Nobody -- nobody -- has shown me a valuation of future cash flow model from 1995 that foresaw any of the stock prices we have now. And nobody has an accurate model for what will happen next.

Fair valuation is an unknown. The quality of a business is a known. We should place much more importance on what we can know. We should invest in the highest quality companies we can find.

In my case, I invest at what I feel are reasonable valuations given my risk tolerance, time frame, and whether or not I'm dollar-cost averaging. Even when averaging into a stock, I hope (as does the Drip Port) to begin buying at what are reasonable valuations in my opinion, but it isn't incredibly important if I'm wrong by a reasonable degree for a few years, especially when dollar-cost averaging. The key word is "reasonable." Long-term investors should seek what they feel are reasonable valuations in great companies. Next, they should hope to be reasonably correct in their evaluation of a stock's near-term potential, and much more correct in their evaluation of the long-term outcome.

Valuation is subjective. Everybody has their own notion of what fair value is. The prices on the stock market usually represent a reasonable common ground. I agree with most current prices (including AOL, Intel, etc.), but if the economy suddenly turned sour and the outlook wasn't so bright, stocks would be worth less to me for a few reasons, including less-certain growth. That's how subjective valuation is and how so-called "fair value" can turn on a dime. It can also change with any breaking news.

A Fool named George (GLSmyth) wrote a fine response to Brian's letter (isn't there a movie called Brian's Song?). You can read it here: George's Post. After reading it, please feel free to share your thoughts regarding price vs. value and fair valuation.

To close, I don't believe valuation is antiquated and I do know it's important within reason. We aim to invest the Drip Port's money in good value situations. However, I feel that arguments about the fair valuation of specific companies have always been, well... overvalued. People have different opinions. Because the stock market can only either go up or down, someone always appears correct at times. It doesn't mean he or she is a genius. Yesterday's market genius is often wrong tomorrow. However, if you consistently invest in quality for the long term, it's hard to be wrong.
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