There is an investor’s adage, “Price is what you pay; value is what you get.”  Thus, every share of stock has a value, here called the Derived Model Value, which is independent of its current stock market price. At any point in time, the stock market price may be roughly equal, significantly higher, or significantly lower than the stock’s Derived Model Value. In cases where Derived Model Values and market prices diverge meaningfully, investment opportunities arise.

While some observers maintain that the market price is the single best estimate of value, we contend that over short periods of time, market prices are heavily influenced by the emotions of market participants. This may serve to push prices further from or closer to a reasonable approximation of Derived Model Value. Over sufficiently long periods of time—five years and longer—the stock market price tends to revert toward an accurately appraised Derived Model Value as the underlying economic earnings will dominate the ephemeral hopes and fears of investors in explaining the value of the business.

The accuracy of the Derived Model Value is subject to the quality of the inputs (as with most models in the social sciences, its efficacy can be described by GIGO, “garbage in-garbage out”). In estimating the fundamental variables to derive the Derived Model Value, we adopt an interdisciplinary approach, trying not to exclude anything that can help us forecast normalized earnings, the projected growth rate, and the terminal multiple. In addition to current financial statements, we assess industry economics, statistics and probability theory, politics and the regulatory environment, as well as psychology and consumer behavior.

In the absence of a user specified input, the Derived Model Valuator assumes that an individual company’s terminal valuation will revert toward a terminal “market” valuation. The basis for this rests on the economic theory that high returns on capital will attract competition. Conversely, low returns on capital will eventually cause competitors to drop out. In certain circumstances, it may be assumed that a company has a sustainable competitive advantage that capital alone cannot overcome, or that a lousy business will stay a lousy business indefinitely. In such cases, the mean reversion assumption may not be warranted.

It can also be seen that the growth rate is but one component in determining the Derived Model Value, contrary to some notions of “value” and “growth” being mutually exclusive.

The rate used to discount future cash flows to their present value reflects not only the time value of money and inflation expectations, but also attempts to compensate for the inherent “risk” as well. We do not, however, define this risk as the past price volatility or attempt to gauge the future price volatility. The “risk premium” is meant to represent the uncertainty regarding the size and timing of the cash flows the business will produce, and the degree to which management can be counted on to channel the cash produced by the business to reward owners.