The so-called "hard" efficient market theory has largely been discredited as academic nonsense, thanks to the rise in the far more accurate real-world behavioral finance approach. The belief is that humans are not always rational, they do not always pay reasonable prices for assets, and markets are not always reflective of economic reality for a variety of reasons. When stock prices begin to fall, inexperienced investors sometimes freak out because they don't understand that every asset has two prices.
How Intrinsic and Present Value Differ
- The Intrinsic Value: The approximate net present value of the after-tax, inflation-adjusted discounted cash flows between now and the end of time
- The Present (or Market) Value: What other people are willing to pay you for the asset at any given moment
The intrinsic value and the market value often line up over time because people are mostly reasonable when life is calm, and there's nothing strange going on in the world, but there can be periods or conditions under which they diverge wildly. You know this on some level, whether you realize it or not.
Imagine you own a seasonal ice cream stand near popular ballfields in a major city. From selling shakes, malts, banana splits, ice cream cones, hot dogs, and Coca-Cola, it produces $30,000 a year in after-tax income on net tangible capital of $30,000; a mouth-watering 100% return. Every summer, you hire a few teenagers to run it, make sure things are going alright, and collect the stream of earnings. It's never going to grow much beyond inflation, but it's a lucrative operation.
Now, imagine someone approaches you and offers you $5,000 to buy it. You'd laugh in their face. Why? Even if you haven't bothered to perform the actual intrinsic value calculation, you already know the market value he or she is offering is a mere fraction of that intrinsic value. There is no way you're going to accept something so inappropriate.
Now, picture this person offering you $3,000,000. You'd jump on it in a heartbeat because even without taking out a calculator, you know the market price that is being offered far exceeds the intrinsic value. You could never make that much from the ice cream stand, so you're better off taking the cash and investing it in something else.
Productive Assets With Intrinsic and Present Values
All productive assets in the world are the same way. Stocks are merely proportional ownership in businesses like the ice cream stand. You have to look at what you're getting for the market price at any given moment and not be quick to sell a great holding just because the market price might exceed its intrinsic value at any particular time. The real money—the life-changing, generational wealth—is more often made by holding fantastic cash generators over 25+ year periods, not trading. If you doubt it, I'd argue you aren't paying very close attention to math or history.
How many people bragged about a quick 20% gain buying a firm like Coca-Cola at one price and selling it at another, constantly trying to flip it as if it were a piece of rundown real estate? Instead, had they parked a single $10,000 lump sum in it on the day it was born, reinvested their dividends, and done nothing else, they'd now be sitting on $1,020,939 in stock. In addition, they would have watched their position rise by 10,109.39%, and enjoyed a 15.09% compound annual growth rate. If they'd dumped $10,000 a year into those crisp, green stock certificates for the Atlanta-based juggernaut, the numbers would be breathtaking.
A Well-Diversified Portfolio Helps With Intrinsic and Present Values
Even if you occasionally experience a business bankruptcy, as you are statistically likely to do, you can still make money in a well-diversified portfolio as a result of the mathematics of diversification. To provide a real-world illustration, a long-term investor in a firm like Eastman Kodak at the time it was enjoying the height of its reputation wouldn't have walked away empty-handed despite the stock going to $0 due to the dividends and spin-off of the chemical division.
The exact degree of loss depends on whether you reinvested the dividends back into Eastman Kodak itself or the portfolio as a whole. The risk/reward trade-off between the Coca-Colas and Eastman Kodaks of the world can be bridged through the use of portfolio rebalancing.