Apple Trees And Experience

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Hi Friends,
Only a few stock investors really know how to determine the intrinsic value of any entity. Okay, i agree it seems like an herculean task at first glance, so here's an easy to understand method to it, enjoy it...

APPLE TREES AND EXPERIENCE
If market price is the last thing an investor or manager should look at in determining the value of a business or an ownership interest
in it, the first thing to consider is its fundamental economic characteristics.
There are so many approaches to appraising those fundamentals
that many people use the relatively lazy metric of market
price as a guideline in valuation, but that is a mistake. Of all the
approaches to appraising business value, just a few do virtually all
the hard work, and those are the ones you need. A parable will
illustrate the basics, and the rest of this part will fill in the details.

FOOLS AND WISDOM
Once there was a wise old man who owned an apple tree. It was a
fine tree, and with little care it produced a crop of apples each year
which he sold for $100. The man wanted to retire to a new climate,
and he decided to sell the tree. He enjoyed teaching a good lesson,
and he placed an advertisement in the business opportunities section
of The Wall Street Journal in which he said he wanted to sell the
tree for “the best offer.”

Some Red Herrings
The first person to respond to the ad offered to pay $50, which, he
said, was what he could get for selling the apple tree for firewood
after he cut it down. “You don’t know what you are talking about,”
the old man chastised. “You are offering to pay only the salvage value
of this tree. That might be a good price for a pine tree or even this
tree if it had stopped bearing fruit or if the price of apple wood had
gotten so high that the tree was more valuable as a source of wood
than as a source of fruit. But you are obviously not competent to
understand these things, so you can’t see that my tree is worth far
more than 50 bucks.”

The next person who visited the old man offered to pay $100 for
the tree. “For that,” she opined, “is what I would be able to get for
selling this year’s crop of fruit, which is about to mature.” “You are
not as out of your depth as the first one,” responded the old man.
“At least you see that this tree has more value as a producer of apples
than it would as a source of firewood. But $100 is not the right price.
You are not considering the value of next year’s crop of apples or
that of the years after. Please take your $100 and go elsewhere.”
The third person to come along was a young man who had just
dropped out of business school. “I am going to sell apples on the
Internet,” he said. “I figure that the tree should live for at least
another 15 years. If I sell the apples for $100 a year, that will total
$1,500. I offer you $1,500 for your tree.” “Oh, no, dot-commer,” lamented the man, “you’re even more ill informed about reality than the others I’ve spoken with.”

“Surely the $100 you would earn by selling the apples from the
tree 15 years from now cannot be worth $100 to you today. In fact,
if you placed$41.73 today in a bank account paying 6% interest,
compounded annually, that small sum would grow to $100 at the end
of 15 years. So the present value of $100 worth of apples 15 years
from now, assuming an interest rate of 6%, is only $41.73 not $100.
Pray,” advised the beneficent old man, “take your $1,500 and invest
it safely in high-grade corporate bonds and go back to business
school and learn something about finance.”
Before long there came a wealthy physician who said, “I don’t
know much about apple trees, but I know what I like. I’ll pay the
market price for it. The last fellow was willing to pay you $1,500 for
the tree, and so it must be worth that.”
“Doctor,” advised the old man, “you should get yourself a knowledgeable
investment adviser. If there were truly a market in which
apple trees were traded with some regularity, the prices at which
they were sold might tell you something about their value. But not
only is there no such market, even if there were, taking its price as
the value is just mimicking the stupidity of that last knucklehead or
the others before him. Please take your money and buy a vacation
home.”

The next would-be buyer was an accounting student. When the
old man asked, “What price are you willing to give me?” the student
first demanded to see the old man’s books. The old man had kept
careful records and gladly brought them out.
After examining them, the accounting student said, “Your books
show that you paid$75 for this tree ten years ago. Furthermore, you
have made no deductions for depreciation. I do not know if that
conforms with generally accepted accounting principles, but assuming
that it does, the book value of your tree is $75. I will pay that.”
“Ah, you students know so much and yet so little,” chided the
Old man. “It is true that the book value of my tree is $75, but any
fool can see that it is worth far more than that. You had best go back
to school and see if you can find a book that shows you how to use
your numbers to better effect.”

A Dialogue on Earnings
The final prospect to visit the old man was a young stockbroker who
had recently graduated from business school. Eager to test her new
skills, she too asked to examine the books. After several hours she
came back to the old man and said she was prepared to make an
offer that valued the tree on the basis of the capitalization of its
earnings. For the first time the old man’s interest was piqued, and
he asked her to go on.
The young woman explained that while the apples were sold for
$100 last year, that figure did not represent the profits realized from
the tree. There were expenses attendant to the tree, such as the cost
of fertilizer, pruning, tools, picking apples, and carting them to town
and selling them.
Somebody had to do those things, and a portion of the salaries
paid to those persons ought to be charged against the revenues from
the tree. Moreover, the purchase price, or cost, of the tree was an
expense. A portion of the cost is taken into account each year of the
tree’s useful life. Finally, there were taxes. She concluded that the
profit from the tree was $50 last year.
“Wow!” The old man blushed. “I thought I made $100 off that
tree.”

“That’s because you failed to match expenses with revenues, in
accordance with generally accepted accounting principles,” she explained.
“You don’t actually have to write a check to be charged with
what accountants consider to be your expenses. For example, you
bought a station wagon some time ago and used it part of the time
to cart apples to market. The wagon will last a while, and each year
some of the original cost has to be matched against revenues. A
portion of the amount has to be spread out over the next several
years even though you expended it all at one time. Accountants call
that depreciation. I’ll bet you never figured that in your calculation
of profits.”

“I’ll bet you’re right,” he replied. “Tell me more.”
“I also went back into the books for a few years and saw that in
some years the tree produced fewer apples than it did in other years,
the prices varied, and the costs were not exactly the same each year.
Taking an average of only the last three years, I came up with a
figure of $45 as a fair sample of the tree’s earnings. But that is only
half of what we have to do to figure the value.”
“What’s the other half?” he asked.
“The tricky part,” she told him. “We now have to figure the value
to me of owning a tree that will produce average annual earnings of
$45 a year. If I believed that the tree was a ‘one-year wonder,’ I would
say 100% of its value—as a going business—was represented by one
year’s earnings.”

So what do you think? Great uh. Imagine the simplicity, this is actually a tip of an iceberg culled from the all time financial bestseller "HOW TO THINK LIKE BENJAMIN GRAHAM AND INVEST LIKE WARREN BUFFET" authored by Lawrence A. Cunningham. Need a copy? all you have to do is download the attachment to know how, I'll post the concluding part later on, you Have a successful trading lifestyle, ciao.