The Firm-Foundation Theory

The Firm-Foundation Theory

All investments return are dependent to certain and varying degrees, on future events. That’s what makes the fascination investing. It’s a gamble whose success depends on the ability to predict the future. Traditionally, the pros in the investment community have used one of two approaches to assent valuation: the “firm-foundation theory” or the “castle-in-the-air theory”. Millions have been gained and lost in these two categories. Understanding them is a prerequisite for keeping you safe from serious blunders. During the 1970s, a third theory, born in Academia and named “the new investment technology” became popular in the Wall Street.

The firm-foundation theory argues that each investment instrument, be it a piece of real state or a common stock, has a firm anchor of something called “intrinsic value”, which can be determined by careful analysis of present conditions and future prospects.

When market prices fall below or rise above this firm foundation intrinsic value, a buying or selling opportunity arises, because this fluctuation will eventually be corrected – or so the theory goes. Investing then becomes a dull but straightforward matter of comparing something’s actual price with its firm foundation of value.

It is difficult to ascribe to any one individual the credit for originating the firm-foundation theory. S. Eliot Guild is often given this distinction, but the classic development of the technique and particularity of the nuances associated with it was worked out by John B. Williams.

In his Theory of Investment Values, Williams presented an actual formula for determining the intrinsic value of stock. Williams based his approach on dividend income. In a fiendishly clever attempt to keep things from being simple, he introduced the concept of “discounting” into the process. Discounting basically involves looking at income backwards. Rather than seeing how much money you will have next year (say $1,03 if you put $1 in a saving bank at 3 % interest), you look at money expected in the future and see how much less it is currently worth (thus, next year’s $1 is worth today only 97 cents, which could be invested at 3% to produce one dollar at that time).

The firm-foundation theory. Photo by Elena

Williams was actually serious about this. He went on to argue that the intrinsic value of a stock was equal to the present (or discounted) value of all its future dividends. Investors were advised to “discount” the value of moneys received later. Because so few people understood it, the term caught on and “discounting” now enjoys popular usage among investment people. It received a further boost under the aegis of Professor Irving Fisher of Yale, a distinguished economist and investor.

The logic of the firm-foundation theory is quite respectable and can be illustrated best with common stocks. The theory stresses that a stock’s value ought to be based on the stream of earnings a firm will be able to distribute in the future in the form of dividends. It stands to reason that the greater the present dividends and their rate of increase, the greater the value of the stock. Thus differences in growth rates are a major factor in stock valuation. And now the slippery little factor of future expectations sneaks in. Security analysts must estimate not only long-term growth rates but also how long an extraordinary growth can be maintained.  When the market gets overly enthusiastic about how far in the future growth can continue, it is popularly held on Wall Street that “stocks are discounting not only the future but perhaps even the hereafter”. The point is that the firm-foundation theory relies on some tricky forecasts of the extent and duration of future growth. The foundation of intrinsic value may thus be less dependable than is claimed.

The firm-foundation theory is not confined to economists alone. Thanks to a very influential book, Grahan and Dodd’s Security Analysts, a whole generation of Wall Street security was converted to the fold. Sound investment management, the practicing analysts learned, simply consisted of buying securities whose prices were temporarily below intrinsic value and selling ones whose prices were temporarily too high. It was that easy. Of course, instructions for determining intrinsic value were furnished and any analyst worth his salt could calculate it with just a few taps of the calculator or personal computer.

Bibliography:

Burton G. Malkiel. A Random Walk Down Wall Street, including a life-cycle guide to personal investing. First edition, 1973, by W.W. Norton and company, Inc.