Giorgio Delgado

Core Concepts Of Value

February 18, 2014

My recently added tab, Valuation, was created for the purpose of reciting what I have learned so far in the art of company valuation. I will be meshing together blogging as well as my desire to learn discounted cash flows analysis for investing purposes.

The first concept that I'd like to talk about is the meaning of value.

What does value truly mean? More specifically, what criteria does one use in the analysis of valuation? Time and time again, history has shown the cyclicality of people's understanding of value. At first there is a strong grasp on the subject, where people are quick to understand which management decisions create value, and which do not. But as time goes on, society's desire to make money at unreasonable rates makes people forget that some things simply don't create value. As such, the inevitable rocketing of prices ensues, followed by the suicidal cliff dive that ruins the life-savings of many.

Market bubbles have occurred for hundreds of years; the Dutch Tulip Bulb bubble (1637), the South Sea Company bubble (1711), the great depression (1929), and more recent bubbles like the tech crash at the turn of the millennium as well as the real estate meltdown in 07/08. The reason for these events is that people forget the meaning of value and confuse it with variables that destroy an asset's long term longevity and value.

The Conservation of Value Principle states that anything that doesn't increase cash flows doesn't create value. Thus, when financial engineering is involved to create larger accounting profits, the stock may initially rise but rest assured that it is destined to fall once the market realizes that cash flows have remained unchanged. As such, all stock prices are derived on expectations of future cash flows. When two stocks with the same number of shares are priced differently, the market is including a premium on the more expensive share because of the expectations that the company will generate relatively more cash in the future.

That is why Discounted Cash Flows (DCF) modelling is so pivotal in the analysis of companies - we are making certain assumptions about a company's future cash flows and then valuing those cash flows today. This allows us to find an intrinsic value of the company, which we can then use to see if share prices are currently either too high or too low.

Time allowing, I will continue this series and expand on the concepts of valuation with much more detail.

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