Value: Intrinsic or Subjective

 

(Click here for old post on value investing)

Recently, a young student was discussing business valuation with me. The young fellow was quite intrigued by the business valuation models particularly DCF. He asked me about my preferred model for valuation and I told him that in my view these valuation models are good for having a theoretical viewpoint and conceptual framework but these are very primitive methods and not practical most of the time in the real world. So we need much better valuation theory/methods which can stand on its feet during the evaluation process.

I know many hardcore Value investing followers and once during our discussions one fellow asked (challenged) me if I could suggest a better fundamental valuation method to value the intrinsic value of a business/stock. But I asked him- whether things really have intrinsic value? We value Roses and consider grass to be inferior to roses but just keep humans aside and nothing is more valuable than the others. Things are just IS. So Roses are Red only for us. The valuation we do is not linked with the individuality of that thing (standalone value) but to the relevancy of that thing to us. Without humanity, roses and grass have same value but it is different when they are “valued”. So value is different from valuation. Leave aside human beings and all and everything has same value…objectively everything is equal. But a three dimensional human being can trade all the grain of the world for a glass of water when he is dying of thirst in Sahara desert….a human can kill thousand others for something as abstract as religious sentiments. Can we value the embedded value of a handful of wheat or a glass of water objectively? So value is intrinsic but valuation is subjective. Objective valuation may not even exist (at least for businesses/stocks).

Value is intrinsic but valuation is subjective

Every asset that generates cash flows has an intrinsic value.

Value investing postulates that prices will oscillate towards intrinsic value (one and only one) and so this intrinsic value is an objective value. I have seen many commentaries on value investing and seen many value analysts (like Buffet) criticizing efficient market theory (CAMP model) but at the fundamental level if we can see even value investing believes that price and value should coincide. But first of all, why there is a difference in market price of an asset and its value because theoretically market price and value of an asset should be equal? Value investing assigns irrational behavior (by market) as the reason for this difference. Value investing accuses market to be guided by temporal forces of greed, fear and its changing mood where it completely ignores the economic considerations related to that asset. So if we can see this irrational behavior is the backbone of value investing where they try to unearth hidden gems ignored by wisdom-less market.

So Value investing declares itself to be far superior to the other irrational players of the market and it feels that it is superior just because they try to calculate intrinsic value (though with large numbers of highly subjective assumptions). But this “irrational behavior” is a very weak rationale for the most fundamental part of the value investing since presumed foolishness of others can’t create something very fundamental related to most valuable aspect of human life- Valuation of assets. It is possible that during Covid lockdown in India from Mar-2020 one investor might have sold Laurus labs at 70 due to the fear of covid related unknown or another investor might have sold it in order to arrange money to help poor migrant labors. Can we say that their behavior is irrational just because they sold Laurus labs at 70 which later on touched 350? Were they foolish for the choices they have opted? No, definitely not.

Fear and optimism are the fundamental forces responsible for the direction of the economy. These are as abstract as something can be but still they have the powers to drive and motivate something as material as an economy. When people and entrepreneurs are hopeful and optimist they spend and invest which drives the overall growth of an economy. Major function of the governments is not micro managing productive resources and their allocation but to create an environment where people have the faith and optimism in the government policies and administration. Like, GST was a great financial engineering having the capability to transform and revolutionize the business models and supply chains in India but a Government can always make a mess of this by making unnecessary rules and large number of compliances which will only create confusions, increase the compliance costs, restricts the flow of Input credit…and this will hit the confidence of investors and industrialists hard and they may choose to invest in some other country or cancel their planned investments in India forever. So fear and optimism are not irrational behavior but are the driving forces responsible for growth and preservation in adversity.

It is a misconception that man, material, money and technology are the most important forces driving the economies. Actually economies are just like a big truck. But which part of the truck bears the maximum weight of the cargo/truck? I ask this question all the time and many time I get answers like axle, wheel etc. But this is not correct as it is the humble AIR in the tyres which bears the maximum weight. So, the most insignificant, subtle and least-physical part holds together the most significant. Similarly, Confidence of the people in the economy and the Government is the most important factor driving the investments and thus growth.

Role of Market in “Value” and “Price”

So what explain the difference in price and value? Actually I have always felt that the fallacy may be related to the role of the market. Contrary to the general perception, the role of the market is not to “find the Value” of an asset/stock/commodity but the role of the market is to “price’ these things as an intermediary of the forces of supply and demand. Price of wheat in the market in the year of short production is high and it is low when there is bumper production of wheat in the following year. The price of wheat is not determined by the market keeping in view the relative value (which is same) but as an outcome of demand supply forces. So, the value is perceived individually while the price is determined collectively by demand-supply forces. It is not the role of market to find the true “value” of an asset/commodity but only to “price” it which is impacted and directed by large numbers of complex and diversified variables. Hence, even when value investing finds that value and price are same; market is not doing anything to Value but it is just doing in which it is most efficient- to price.

And all of a sudden, we can feel that this “price” is more objectively arrived at than the “value”. Value investing use highly subjective assumptions like discount rate, growth rate, terminal value, no growth PE ratio etc. and so this makes intrinsic value highly subjective. For example, expected cash flows of an asset are subject to the wisdom/strategy/decision making of an able manager who manages to extract much more value out of an asset due to his wisdom and decision making. And that’s why valuation is subjective- there is no standalone value which accrues to an asset on its own. Value is created by able managers with wisdom and price is paid (and accepted) for this value subject to prevailing market and general economic conditions. Price is what we know and value is what we perceive.

In Real Life Valuation is Subjective

In real life things are also like that. Valuation is subjective- just take the recent case of coffee retail chain Café coffee day (CCD) which is on the verge of sale. Can we say that CCD has one and only one intrinsic value? No, because its value will accrue differently to each buyer. Tata coffee/Tata-Starbucks can extract big synergy by consolidating CCD with them and thus creating more value as compared to other buyers with unrelated business like Dabur or even Coca cola. But the likes of ITC who are trying hard for long time to build a branded FMCG business can see this as a big opportunity and will be ready to pay much higher price because they will be hopeful of creating more “value” than by spending the same money for promoting their other in-house brands. So whenever this will happen there will be a fierce fight for the control of CCD.

Let’s take the case of ITC. ITC has not performed that well in last 10 years or so. So how value investing would have valued ITC 10 years ago could have been very interesting. ITC was churning massive volumes of cash and it had grand plans for doing big in FMCG business. Value investing would have arrived at a very lucrative value keeping in view the past record (in creating a great FMCG brand in Aashirwad) and low cost of capital of ITC. But the most significant part in any business valuation is qualitative part (and impact of intangibles) which is not captured that well by value investing. Just like our traditional accounting which has no tools to evaluate intangible assets. But we all know that net worth in fact is the minimum value as businesses get maximum value from the intangibles like brands, technology, Patents, customer loyalty, information and data which are not assigned any value in the balance sheets by traditional accounting (not much even by Value investing).

So the story moves forward and ITC couldn’t create the value. First, it was not vry wise in allocating capital. It wasted it in hotel business which is highly capital intensive but low return business. In FMCG- apart from Aashirwad it failed miserably. It invested and focused on second standard products in crowded segments like Yippee, Sunfeast, Bingo which are forced choices...nowhere near Maggi, Lays etc. I don't think it could ever be a leader in any of these products...when Maggi was hit badly due to bad press it could not do anything even at that time. Actually Aashirwad was a great venture and I was thinking at that time that ITC would make a killing in Pulses/Spices with its Aashirwad brand but instead they focused on other low margin businesses like stationary/Hotels and other crowded FMCG products with very strong brands. The main reason for me to buy Tata chemicals (Before demerger of branded product business) was their foray into branded Pulses and Spices business and Tata has created a great brand in the last 5 years or so. Tata chemicals has really leveraged its supply chain and brand recall in creating niche products (Tata Sampann Brand). That’s why Tata chemicals is already giving almost three times returns (Including value of Tata consumer post-demerger).

It is very tough to create strong brands in FMCG sector which is already having strong brands. Inorganic growth via acquisitions should have been a much better strategy than building brands from the scratch. In today’s world it is very costly. So I feel a better way for ITC was to acquire a good company in FMCG with good brands like last year Zydus wellness did by picking Complan/Glucon-D and Horlicks was acquired by HUL. These are master steps; CEOs are paid for this. Sometimes I felt ITC should have sensed the opportunity in premium whisky in India and instead of investing capital and efforts in creating new brands in highly competitive FMCG sector related to snacks etc. It should have attempted at acquisitions preferably in liquor sector like Radico Khaitan (who once was looking for a partner). United spirits and UB were picked by Diageo and Heineken but investing 20000-25000 cr for buying these giant Indian brands in high entry barrier Indian liquor industry would have been a much better strategy for ITC and cash was never a problem for ITC. Liquor business is a much better extension of its cigarette business and ITC understands the dynamics of this complex regulated business in India much better than others and that’s why I think ITC could have created more value for United spirits and UB businesses than by the likes of Diageo and Heineken.

So the value is not created in a linear mathematical formula but by human wisdom and strategy which are not confined to any formula or any boundaries. Value is created and perceived subjectively.

Here I remember something- the divine lovers Laila Majnu!! You know Laila wasn't very beautiful but Majnu was a handsome guy. The king of the city liked him and he was very concerned to see Majnu dying for Laila, an ordinary girl. So he invited Majnu to his palace and offered him to pick any girl from his harem having the most beautiful girls of that time. But Majnu declined; king was shocked and asked, “but how can you decline these pretty girls for that ordinary girl Laila…she is nothing against these women?".

"Well, my dear King, to see the divine beauty of Laila...you need my Eyes", was the reply from Majnu.

(Every asset that generates cash flows has an intrinsic value so can we say that Money has an intrinsic value? I have asked this question to the young fellow as his next assignment)

(Views are personal. This post is taken from monthly Newsletter of this Blog. Reach me at oscillationss@yahoo.in)