On Paying a Fair Price
A reader recently sent me an email about Procter & Gamble (PG); that email prompted this post.
You’ll often here people say it’s okay to pay a fair price for a great business. Don’t listen to them. An investor never pays a fair price for anything. There is nothing fair about investing. Remember, there are two sides to every trade. A good investor makes his living by ripping other people off.
That is, after all, what Ben Graham’s Mr. Market metaphor is really all about – a sane man taking advantage of a lunatic. Despite the media’s coverage of the markets, we investors are not all in the same boat together. Investing is a zero – sum game. If you want to match the market, buy an index fund. If you want to beat it, you need to forget about fair prices.
All investments are ultimately cash to cash operations. Owning a great business has no value in and of itself. So, paying a fair price for a great business means you’re giving up as much as you’re getting. There’s no logic in that.
An investor may be wise to buy a great business at a higher price – to – earnings multiple than he is willing to pay for most businesses. But, that isn’t the same thing as paying a fair price. If your intrinsic value analysis shows a stock is currently trading at or above its true value, don’t buy it. It’s really that simple.
Performing an intrinsic value analysis is nothing like slapping a P/E multiple on a stock. A great business may justifiably command a higher price – to – earnings ratio, because of its growth factor. Let me reprint here what I had written in the Value Investing Encyclopedia about a company’s growth factor, because I’m sure many of you haven’t seen it.
A business’ growth factor consists of two parts: the return on capital and the amount of unrealized growth within the franchise. The former governs profitability; the later governs growth.
Only a company that earns an extraordinary return on capital and can deploy additional capital within the franchise can be said to have a truly profitable growth factor. If a business’ return on capital is less than or equal to the average return on capital in the economy, then it does not have a positive growth factor regardless of its earnings growth rate. A company with a very high return on capital and no room left to deploy capital within the franchise will likewise not have a positive growth factor.
I hope to address the issue of just how valuable growth can be in my next post. I’ve only hinted at this before. For instance, I wrote that at a price of just over twenty times earnings, PetMed Express (PETS) was clearly a bargain. My intrinsic value analysis showed it was very cheap. Still, I didn’t buy it. That was a dumb mistake caused by relying on the crutch of conventional valuation metrics.
I hope to better explain my reasoning in the next post. For now, I just want to make clear that whenever I discuss the value of a franchise, I do not mean to suggest that wide moat companies should be purchased at a fair price. You must never pay a fair price for any business.
I will let Mr. Buffett present my case. As usual, I am quoting from Warren’s best letter, the 1992 letter to shareholders:
“What is ‘investing’ if it is not the act of seeking value at least sufficient to justify the amount paid? Consciously paying more for a stock than its calculated value – in the hope that it can soon be sold for a still-higher price – should be labeled speculation (which is neither illegal, immoral nor – in our view – financially fattening).”
“The investment shown by the discounted-flows-of-cash calculation to be the cheapest is the one that the investor should purchase – irrespective of whether the business grows or doesn’t, displays volatility or smoothness in its earnings, or carries a high price or low in relation to its current earnings and book value.”
“If we calculate the value of a common stock to be only slightly higher than its price, we’re not interested in buying. We believe this margin-of-safety principle, so strongly emphasized by Ben Graham, to be the cornerstone of investment success.”
Never pay a fair price for any business. Sometimes, it makes sense to buy a stock with a P/E over 20. It’s rare, but it happens. Sometimes, it makes sense to buy a stock with a price – to – book ratio of seven or eight. It’s rare, but it happens. Sometimes, it even makes sense to buy a stock with no earnings at all.
But, it never makes sense to pay more than you think a business is worth. Whenever you pay a price equal to or greater than your estimate of the intrinsic value of the business, you are speculating – regardless of the quality of the business in which you are buying shares.