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Intrinsic vs. Exchange Value

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By captainccs
January 4, 2007

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I've had the book for several years but I never had the time to read it. Now I'm starting to read Ben Graham's 1934 edition of Security Analysis. Of course, my first priority was to discover what they have to say about intrinsic value. It immediately becomes clear that intrinsic value is the fair value or fair price of an asset and that it can be different than its current market price. So far so good. Unfortunately, Graham and Dodd do not tell you how to calculate it. They say that at one time it was believed that intrinsic value was the same as book value but that this did not prove to be practical in everyday application. Next, people figured that intrinsic value should be given by "earnings power" but this too proved to be difficult to use in practice. So we are left without an exact definition of the term. Despite these difficulties, they insist that intrinsic value should be used by the security analyst. I quote:

Let us try to formulate a statement of the role of intrinsic value in the work of the analyst which will reconcile the rather conflicting implications of the various examples. The essential point is that security analysis does not seek to determine exactly what is the intrinsic value of a given security. It needs only establish either that the value is adequate -- e.g, to protect a bond or to justify a stock purchase -- or else that the value is considerably higher or considerably lower than the market price. For such purposes an indefinite and approximate measure of the intrinsic value may be sufficient. To use a homely simile, it is quite possible to decide by inspection that a woman is old enough to vote without knowing her age, or that a man is heavier than he should be without knowing his exact weight.

Security Analysis pages 18 and 19.

In the following paragraphs, Graham and Dodd say that you don't always need "an exact calculation of the intrinsic value" to accept or reject securities. In the specific cases they mention, they compare the earnings record of the company to the burden of the bonds to determine whether to accept or reject them. In a further example they state about Wright Aeronautical: "But fortunately it was not necessary to decide these points [the actual worth] in order to conclude that the shares were attractive at $8 and unattractive, intrinsically, at $280."

Next they talk about the "Principal Obstacles to Success of the Analyst:" (a) Inadequate or Incorrect data, (b) the uncertainly of the future and (c) the irrational behavior of the market. The first two are easily dismissed: the security analysts should be able to detect faulty data and deal with it [really?] and since there is not much anyone can do about the future, just apply the technique to the most stable of securities [good advice!]. The real obstacle is the irrational market. If the investor would just not look at prices, everything would be great but "[o]wners of securities, whatever their character, are interested in their market quotations."

Since the securities analyst is obliged to deal with security prices, i.e. the market, Graham and Dodd briefly describe its actions: "first, the market price is frequently out of line with the true value; and second, that there is an inherent tendency for those disparities to correct themselves" [revert to the mean]. Talking about "The Hazard of Tardy Adjustment of Price to Value" Graham and Dodd state that while it will happen in theory, in practice "its working is most unsatisfactory" because "the undervaluation may persist for an inconveniently long time and the same applies to inflated prices caused by overenthusiasm (sic) or artificial stimulants."

I have quoted enough of Graham and Dodd to make my point. The concept of intrinsic value is sound provided you accept that there is no way to calculate it, all you really need is a ballpark figure (old enough to vote and too fat). This being the case, pseudo exact figures produced by DCF calculations are moot. Graham and Dodd are saying that fundamental analysis is more art than science. As hard as they try to distance themselves from security prices, reality forces them to deal with the irrationality of the market. When they do, they are talking 100% BMW Method: prices will oscillate around the true value! That being the case, the mean price as shown in a BMW method chart is about as close as we can get to figuring out the true value, the intrinsic value of any security. The chart then helps us pick entry and exit points.

The mean price is established by long term trading of a security and, as such, I feel amply justified to call this mean "the exchange value of the security" because this value is established by repeated exchanges of the security between multiple buyers and sellers.

BTW, welcome to 2007!

Denny Schlesinger


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