Creating Value in an Equity Investment: The Basics

In my PGDM, the Business Strategy paper described a framework called the 'Value-Cost Framework'. That is to say, a buyer creates value for himself by paying a price which is lesser than what he is willing to pay for a product or a service. Of course, this was taught in the context of Value Creation in Marketing. But it’s not so different in the context of Common Stocks.

The following diagram gives you a basic idea:

(Source: Haas-Berkeley)

Not so surprisingly, there's a simpler quote by Warren Buffet explaining the same phenomenon:

A long time ago, Ben Graham taught me that price is what you pay and value is what you get. Whether we're talking about socks or stocks, I like buying quality merchandise when it is marked down.

---

We should go back to Accounting 101 in order to understand Equity Investments. Do you remember how you were taught about what a Balance Sheet represents? I hope you remember the following “formula”:

$Assets\; =\; Liabilities\; +\; Equity$

So, when you invest in Common Stocks:

(Source: WikiHow)

When you pay for the “Owner’s Equity” or otherwise stated, buy the shares of a company, you acquire the following:

1. Operating Assets: These are the assets with which the company operates its core business. A majority of the profit and loss statement of a company can be attributed to these assets. Think about giant plants in a manufacturing firm. They cost a lot and require maintenance, but they also generate products for the company to sell and profit.
2. Non-operating Assets: These assets are not technically in the business. They don’t produce cash flows for the business. Think about Real Estate which is not rented out by the business. Their market value is probably a lot higher than what is seen in the Balance Sheet of the company (Thanks to ‘prudent’ Accounting practices).
3. Cash and Cash Equivalents: The actual cash the company has in its bank accounts. Other receivables and inventory, which are easily convertible into cash, are called Cash Equivalents.
4. Debt and other Liabilities: Unfortunately, you also take over and effectively, owe the debt and other liabilities of the company.

---

We talked about ‘Value’ in a previous section. The first step in identifying value is understanding the maximum price you would be willing to pay. You do this by valuing the Operating Assets, adding the market value of the Non-operating Assets, adding the Cash and Cash Equivalents and then deducting the Debt and liabilities.

As an example, I’ll show you an Equity Valuation I did recently using a simple Discounted Cash Flow model:

(Reference: Numbers and Narratives: A Simple Discounted Cash Flow (DCF) Model for Equity Valuation)

What this really says is, if Maruti Suzuki were to trade below ~Rs. 5900 levels, I would start looking at it for an investment opportunity. Of course, even if I do invest in Maruti Suzuki at that level, I may not realize the value right away. In fact, it may take several years. Thankfully, my willingness to pay will also grow with time, depending on how the company operates. I can wait out several years, as long as I earn my value in Present Value terms.

---

All this may sound easy, but is actually quite tricky to do. I would suggest that you take free online courses like the one offered by Prof. Aswath Damodaran and start experimenting with valuation model(s). Of course before you even get there, you need to grow your own investment style — here is mine.