Alpine Capital Research - Fundamental Valuation Theory

Fundamental valuation theory serves as the intellectual foundation for our investment principles and strategies. The theory is also consistent, in our opinion, with a healthy financial system.

The following is a unifying theory of capital valuation for the investor.

(i) The objective of enterprise is to generate wealth by providing society with more utility or less labor. The objective of finance is to allocate capital to worthy enterprises. Society is thus served by wealth maximizing enterprises and investors. The term “enterprise” refers primarily to private enterprise. Broadly defined, “enterprise” also refers to governments and consumers (in which latter case “enterprise” consists of labor and savings).

(ii) Enterprise financial markets match (a) enterprises seeking the lowest cost of capital with investors seeking the highest return on investment, and (b) the liquidity and cash use needs of enterprises with the liquidity and cash return needs of investors.

(iii) Enterprise financial markets comprise securities which represent claims upon enterprises. Enterprise value is equivalent to the value of all the securities which have a claim upon the enterprise. Securities with senior claims have less risk, less volatility, and lower yields than securities with subordinate claims. Derivative financial markets comprise securities (or contracts) which represent claims upon securities, assets, or events. Derivative financial markets enhance economic value when they facilitate more effective resource allocation.

(iv) Value depends in part on the timing and intensity of enterprise cash uses and the timing and intensity of investor cash needs. Enterprises and investors who desire cash at a certain time value the cash at that time higher than cash at other times.

(v) Enterprises retain capital when their return on capital is higher than their cost of capital, and enterprises return capital to investors when their return on capital is lower than their cost of capital.

(vi) Fundamental value is equivalent to future security cash flows discounted at a rate which reflects security risk, information costs, transaction costs, cash flow duration, and taxation. Fundamental risk is the likelihood and potential magnitude of a decline in security cash flows, or the payment of a market price at purchase which is higher than fundamental value. Market price is what a buyer and seller have agreed to exchange for a security. Information costs refer to the time and cost required to value a security. Transaction costs refer to commissions and other execution costs. Duration is the weighted average term to maturity of the security’s cash flows. Risk increases with duration.

(vii) Perfect knowledge of fundamental values implies market participants know (a) as much about the variables which establish a security’s value as all other market participants, and (b) as much about the values of all securities in the marketplace as all other market participants. Perfect knowledge cannot be attained. Market participants who know more about the variables which establish fundamental value may earn higher risk adjusted returns than market participants who know less.

(viii) Knowledgeable market participants allocate capital to worthy enterprises and securities by estimating fundamental value and transacting when the difference between fundamental value and market price is greater than information, trading, and tax costs.

(ix) The more robust the investor’s knowledge of a security’s value, the greater the difference between fundamental value and market price, and the lower the risk of the security, the more wealth an investor will concentrate in the security.

(x) Investors seek diversification of the risk factors acting on a portfolio, where risk factors are economic facts which could negatively affect the cash flows of the securities in the portfolio. Portfolio risk and cost of capital decrease with additional risk diversifying investments when investor knowledge, investment valuation, and investment risk are held neutral.

(xi) Systemic risk represents one risk factor acting on all securities. The failure of an entire economic system represents full systemic risk realization. The probability, magnitude, and correlation of loss among securities increase as systemic risk increases. The risk reducing benefit of diversification decreases with increased systemic risk.

Rational, well informed, market participants and the alignment of theoretical and actual incentives are required for the theory to be valid in practice. The author’s opinion is these conditions are not always present, which can cause the misallocation of capital and enrich or deprive respective market participants.