Benjamin Graham and David Dodd, writing in their 1934 investment classic, Security Analysis, opined that intrinsic value is distinguishable from price in the securities markets.  Countering the vogue that developed during the 1920s (historically known as "The New Era"), and which remains prevalent in the 21st Century, the authors argued against the postulation that "stocks are worth nothing more and nothing less than the price at which they are currently selling".  The authors admonished practitioners of the New Era mania and provided a lesson for the generations when they wrote, "Instead of judging the market price by established standards of value, the new era based its standards of value upon the market price."¹  Today, market price continues as the dominant, if not exclusive, indicator of value for common stock securities among the overwhelming majority of market participants.  And as a result of this, the "established standards of value" alluded to by Graham and Dodd, continue to wallow in virtual obscurity.

The concept that price is the same thing as value is an exceptionally easy pill to swallow.  Every day many billions of individual consumer goods and services, or the raw materials that will become consumer goods, are exchanged throughout the global economy; and "the price is the value" approach works exceedingly well for those transactions.  The marketplace is considered the best judge of value; people decide how much of one good or service they are willing to exchange for another, through a medium of exchange, like dollars, yen, etc.  And if enough consumers are willling to part with $3,000 for a particularly stylish watch, then that commodity's value is established by the price that market participants routinely pay.  This is a grossly simplified explanation of market value; however, as it relates to the point at hand, it will suffice.  The very same illustration may be used to establish the value of works of art, designer handbags, notebook computers, and many other assets . . . including homes.  Accumulate enough statistics on what a commodity sold for in the marketplace, and its value may be stated with high confidence. The broader and deeper the statistics, the more accurate the assessment is considered to be. 

Problems arise at times with marketplace valuation, however.  The market approach rests upon the assumption of an arms length transaction where the implicit question, "what would a willing buyer pay to a willing seller today for 'X' commodity/service?" is asked.  The indispensable element here is both parties' willingness.  What if a buyer's or a seller's will changes?  That is, what if a buyer's willingness to pay money drops precipitously because of fear, dread, shock, and outright fright . . . or rises by an alarming rate because of optimism, ectasy, and outright euphoria?  The result is that the value of an asset becomes skewed.  For items like watches, handbags, and homes, no independent method of valuation exists to moderate this excessive skewing.   Home prices, as experienced recently, did not have a dampening effect on their upward spiral precisely because there was no independent method of valuation that existed beyond that of a comparative marketplace valuation.  As a result, home prices spun out-of-control until a massive economic calamity interrupted the cycle of grossly inflated sales, subsequently higher-inflated appraisals, and then even more grotesquely inflated sales prices.  However, stocks . . . which are nothing more than businesses . . .  can be independently appraised and thereby valued without reference to the market.  This thinking is apparent from the Graham and Dodd quote above: they refer to being able to "judge the market [price]" by established standards of value.  You can only assess the efficacy of the market price, if you have derived a stock value from some method independent of the market.  The indispensable reason that stock (or business) values may be derived independent of the market, but consumptive items like watches, handbags, and peoples' residences cannot is because the former provide their owners with an ongoing return on invested capital, whereas the latter do not.  

Security Analysis was written during the darkets moments of the Great Depression; and many of the lessons that Graham and Dodd espoused were meant to address both the unprecedented over-inflation of stock prices in the late 1920s and their subsequent monumental shrinkage during the early 1930s.  Of primary importance to Graham and Dodd was the fact that stock values were being derived for the New Era from the same method that attaches to handbags, watches and Dutch tulips; and this was happening despite overwhelming evidence (for those who bothered to study) that the value of a business could be derived without reference to the marketplace.  

Graham and Dodd actually took their academic discussion and translated it into a investment business model: If the intrinsic value of a business (derived by reference to return on capital, financial stability, etc.) was significantly greater than the current market price (this occurred in the early 1930s and in 2008-2009), then one could establish a wide "margin of safety" in making securities purchases.  Alternatively, intrinsic value could also point to exhorbitantly overpriced securities in the marketplace (think dot.com mania of 1998-1999).  The authors used many decades of experience and research to determine that, in the long run, a security's market price eventually found its way into a close proximity with its intrinsic value; and because of this fact, one could be confident that a purchase on the merits of intrinsic value would eventually be rewarded with a market value that reflected it.  This singular investing point of view has propelled Warren Buffett to billions of dollars in securities profits over many decades.  It was no mistake or mere coincidence that Warren Buffett was the only student in more than 35 years to earn the grade of A+ in Professor Graham's investment course at Columbia University. 



1. Benjamin Graham and David Dodd, Security Analysis, pg. 310  (1934)