Shouldn't all stocks trade at discount to company value?

[Mark1808]

Warren Bufffett has said he looks to acquire stocks selling at significant discounts to what the company as a whole would be worth to a knowledgeable buyer. In estate planning fractional interests are giving varying discounts for valuation purposes known as a minority discount. These discounts can be 25% and more and reflect the fact that a partial interest can’t influence disposition of a company as a whole (they also include marketability discounts which don’t apply to stocks). This is born out in real life as we almost always see the acquisition of a company take place at a premium to the market price. This raises the question that shouldn’t stocks be valued at a discount to the value of the company as a whole in an efficient market anyway? So when one buys a stock below company value they really aren’t getting a bargain because that fractional interest should be valued below company value.

[ArturiusX]

Firstly, define "should".

[Mark1808]

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Firstly, define "should".

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Effecient. If stocks were priced effeciently they should trade at a discount to the value of a company as a whole. Finding a stock trading at such a discount theoretically doesn't present an opportunity unless the discount is substantially larger then would be appropriate for that paricular stock.

[DesertCat]

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Firstly, define "should".

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Effecient. If stocks were priced effeciently they should trade at a discount to the value of a company as a whole. Finding a stock trading at such a discount theoretically doesn't present an opportunity unless the discount is substantially larger then would be appropriate for that paricular stock.

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EM thinks every stock should be valued at a price that implies a market average return going forward. A discount is a price that implies a greater than market return in it's future. If all stocks traded at discounts, then the market's returns would be greater than the market's returns, which can't happen in this universe.

Obviously for some stocks to be traded at a discount to their value, others have to be traded at a premium. Stocks can trade over value because it's investors perceive future growth prospects as greater, and more certain, than they actually are. High growth stocks are inherently difficult to value due to their value being in the discounted for time value of their future cash flows. Any DCF analysis of a company like that can produce large ranges of estimated values based on relatively moderate changes in assumptions. Stocks can also trade higher because of psychology like "momentum", i.e. traders continue to bid them up thinking momentum will last.

[stinkypete]

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If all stocks traded at discounts, then the market's returns would be greater than the market's returns, which can't happen in this universe.

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but if they continue trading at that same percentage discount in the future, the returns will be the same...

some counterarguments to the OP:
- if you own whole companies that individually make up a significant part of your net worth, you're exposed to more risk. several smaller investments that diversify your risk will be "worth more" to you, even if their expected value is slightly lower. the biggest companies (market caps in the hundreds of millions) are worth many times the richest individual's net worth, so the "true value" can never be realized.
-liquidity increases a company's value. if you own the whole thing, how are you going to find buyers at the "true value"? if you need to liquidate, the company is only worth what you can sell it for.

[bmxicle]

I'm not sure that having a minority interest provides you with less value. When you buy a stock, you are buying a part of the abilities of the management to direct the activities of the company along with a piece of all its assets, future profits and current cash flows. So in order for a minority interest to be worth less, that would be saying that you could do a better job than the current management, and most investors are not willing to spend the huge amounts of time to run a company, so instead they buy a piece of the company, with one of the intangible assets being managements ability.

I think it might actually be the reverse of what you are saying. The reason you have to pay a premium for getting a majority interest is because to do so you have to bid up the price of a stock by buying over half of it. A controlling interest is worth enough to you--economies of scale, you can use the assets better etc.--to bid up the price of the stock and pay a premium over normal value. The difference between the person taking a controlling interest and the real value is the premium you have to pay and seems to me the discount you would be referring to. So the discount comes out of someone who needs a controlling interest's pocket, not a value investors valuation.

[adios]

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Firstly, define "should".

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Effecient. If stocks were priced effeciently they should trade at a discount to the value of a company as a whole. Finding a stock trading at such a discount theoretically doesn't present an opportunity unless the discount is substantially larger then would be appropriate for that paricular stock.

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EM thinks every stock should be valued at a price that implies a market average return going forward. A discount is a price that implies a greater than market return in it's future. If all stocks traded at discounts, then the market's returns would be greater than the market's returns, which can't happen in this universe.

Obviously for some stocks to be traded at a discount to their value, others have to be traded at a premium. Stocks can trade over value because it's investors perceive future growth prospects as greater, and more certain, than they actually are. High growth stocks are inherently difficult to value due to their value being in the discounted for time value of their future cash flows. Any DCF analysis of a company like that can produce large ranges of estimated values based on relatively moderate changes in assumptions. Stocks can also trade higher because of psychology like "momentum", i.e. traders continue to bid them up thinking momentum will last.

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Many flavors of EM theory but one thing I believe you didn't mention and that is that mispricings occur at random.

[DesertCat]

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Many flavors of EM theory but one thing I believe you didn't mention and that is that mispricings occur at random.

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I've never heard that before, can you shed light on how they arrived at this? To me "at random" sounds like "there are some many influences that create mispricings that we can't figure out what the primary causes are".

[Mark1808]

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I'm not sure that having a minority interest provides you with less value. When you buy a stock, you are buying a part of the abilities of the management to direct the activities of the company along with a piece of all its assets, future profits and current cash flows. So in order for a minority interest to be worth less, that would be saying that you could do a better job than the current management, and most investors are not willing to spend the huge amounts of time to run a company, so instead they buy a piece of the company, with one of the intangible assets being managements ability.

I think it might actually be the reverse of what you are saying. The reason you have to pay a premium for getting a majority interest is because to do so you have to bid up the price of a stock by buying over half of it. A controlling interest is worth enough to you--economies of scale, you can use the assets better etc.--to bid up the price of the stock and pay a premium over normal value. The difference between the person taking a controlling interest and the real value is the premium you have to pay and seems to me the discount you would be referring to. So the discount comes out of someone who needs a controlling interest's pocket, not a value investors valuation.

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Well the IRS allows minority discounts to estates and the merits have been argued in court. A cottage industry exists to prove that minority discounts should be afforded to minority holders. Stocks are a minority holding and therefore should theoretically be valued at a discount to the value of a company as a whole. These discounts in the market do not represent an opportunity as much as they represent effecient pricing.

Control has value, that is why premiums are paid in buy outs. I am thinking that Buffett's requirement of a 50% discount to company value does not represent a risk premium as much as it represents the fact that a stock priced effeciently should sell at some discount no matter what and a 50% discount means the stock is priced too cheaply while a 15% to 20% discount may be fairly priced.

It is pretty hard to argue that stocks should trade at a discount to company value when virtually every buy out involving an informed buyer is made at a premium to market. Either every buy out is made at a premium to intrinsic value or stocks reflect a minority discount.

[stephenNUTS]

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-liquidity increases a company's value. if you own the whole thing, how are you going to find buyers at the "true value"? if you need to liquidate, the company is only worth what you can sell it for.

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Very valid point IMO... although there might be such a DEMAND for certain isolated illiquid public companies,where they will pay WHATEVER "true value" they want to aquire that entity...even though it may be at a much higher premium to its peers.

In fact in most cases they HAVE to pay higher,just due to the liquidity issues alone in an example like that

SF [img]/images/graemlins/cool.gif[/img]