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Subject: Valuation of RBs and RMs


Thanks for your reply to my Message No. 78. I agree with you completely, that once you have bought shares in a really great company, a person shouldn't worry about the price, since the performance of the company is much more important. I agree that an investor should hold such companies as long as they are maintaining their market position and hopefully you can hold them forever. I believe that this is why Warren Buffet hangs on to Coca Cola and Gillette. He can never really lose on these investments since the share price is now so much higher than his purchase price.

The difficulty for me, and I suspect many others, occurs when you do not yet own shares of one of these great companies. You have to determine a price at which you are ready to jump in. You want to buy the shares at a price which you believe will bring you a reasonable return on your investment. For example, if you had bought Iomega at it's peak price, you would have lost a lot of money, even if the company was and still is a great company. Even if you now keep the company for the rest of your life, it will be a long time before you get back the money you lost on the initial purchase.

I believe, therefore, that when you don't already own shares in a great company, or if you want to add to your position, the market price for the shares becomes very important. If you agree with this, then it follows that we must have a method to determine what a reasonable share price might be, for both Rule Breakers and Rule Makers.

As a suggestion, it might be useful to break the share price into a “tangible” component and an “intangible” component. (You may wish to introduce other terms, its just that engineers have a fairly limited vocabulary). The tangible component is that portion of the current market price which we can justify based on known information. For example, in the case of Rule Makers, we can estimate the tangible share price based on this years earnings, the historic earnings growth rate and the historic price to earnings ratio. In the case of Rule Breakers, we might estimate the tangible component of the share price by estimating the size of the market, potential revenues and estimated net earnings. My opinion is that even if these estimates are fairly crude, they can give investors a framework in which to monitor the performance of a particular company. For example, there has been some useful discussion on what At Home's maximum and minimum revenues and profits might be expected to be several years from now, which helps to determine whether the current market price is reasonable.

The intangible component of the share price is that portion of the current market price which exceeds the tangible share price. In my view the intangible component represents the speculative portion of the share price. If there is some bad news, either about the economy or about the particular company, then it is the speculative portion of the share price which can justifiably drop to zero. If the price drops lower than the tangible share price, then I would happily jump in and buy lots of shares. (Assuming that the company's overall performance had not changed).

The bottom line of all this is that if we want to buy shares in a great company, or we want to add to our position in a great company, we should wait until the market price approaches our estimate of the tangible price. Having said all of this, you should know that to my great chagrin, I have been waiting for several years for the market price of CSCO and MSFT to fall to within striking distance of what I believe is their tangible share price, and they never seem to come close. So maybe we need to have a third component of the share price called the tangible portion of the intangible component of the share price ….just kidding :>)

I look forward to any comments you or anyone else may have on these ideas.

Fool's Forever!

Bruce Smith

PS: Paco – No kidding – did you really smoke crack with Kathy Lee Gifford? I'm impressed!
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