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)