By
Borsgade
In an interview with The Motley Fool, Bill Nygren explains why it is important to buy a stock at a discount to its intrinsic (intrinsic) business value, as it reduces risk and amplifies the potential reward.
He believes that stocks will trade reasonably close to intrinsic business value most of the time, so buying at a discount to intrinsic value means that the expected terminal value is a higher than the real business value. This reduces risk because the investor is less likely to lose money if the stock price falls.
Efficient market theorists will say that regardless of the price you pay, you can get a fair return relative to the risk you incur. However, if you believe as we do, that most of the time a stock will trade reasonably close to intrinsic business value, then buying at a discount to business value beats a mostly efficient market.
By purchasing at a discount to value, risk is reduced because the expected terminal price is a higher percentage of business value. Further, reward is amplified for the same reason, the terminal value is a higher percentage of business value. The efficient market hypothesis would say that an investor’s holding period return should roughly match the change in business value during that time.
To that, we add the increase in price due to the gap closing between initial price and initial value. Note that paying more than business value has exactly the opposite effect.
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