Buy a business for 80 cents on the dollar, and you’ll earn an above market rate of return in the stock market.

Stocks are part ownership in a business. Businesses may have intrinsic value, a value “in itself” separate from any stock market value. Businesses have an intrinsic value only if they produce a profit for owners or will produce a profit for owners sometime in the future. A business with no profits and no reasonable prospect of profits has no intrinsic value and shouldn’t be purchased, unless it has salvage value (plant, equipment, and inventory that can be sold at a price above the acquisition price). Intrinsic value, then, depends on a business’s current and future profits to owners. Correctly assess a business’s intrinsic value and buy a part of that business when the stock market price is lower than that value and you will not only make money, you will also outperform the market.

It is easier to value current profits than to value future profits. Future profits are less certain and less certain future profits shouldn’t carry the same valuation as existing profits. The further away the potential future profits the less value they have. Businesses with high current profits have more intrinsic value than businesses with low current profits, both because high current profit businesses have more profits, and because profits received now are worth more than profits received later. Profits received now are worth more than profits received later because of the time value of money. The time value of money means a dollar today is worth more than a dollar one thousand years from now (an extreme example that makes the point). The difference between a dollar today and a dollar in ten years is the expected return on the dollar received today over a ten-year period. A dollar that is invested today and earns 7.2% per year over ten years is worth $2 dollars in ten years, twice as much as the dollar received in ten years.

The intrinsic value of a business also includes the expected growth in future profits. Future profits aren’t worth as much as current profits, but they certainly add to intrinsic value – if they materialize. Investors should assign value to future profits based on a reasonable estimate of the amount and timing. In other words, growth in profits have value. Most investors assign too much value to future profits and insufficient value to current profits. How do we know? The data tells us.

Bank of America/Merrill Lynch did a study in 2016:

“Based on the study findings from Bank of America/Merrill Lynch over a 90-year period, growth stocks returned an average of 12.6% annually since 1926. However, value stocks generated an average return of 17% per year over the same timeframe.” (Motley Fool, June 2016)

In fact, value appears to outperform growth by between 2.5% and 4.0% per annum over the long run depending on which database you use. Ergo, most investors assign too much value to future profits (buying growth) and insufficient value to current profits.

Pay less for an asset than it’s worth and you will earn an above market rate of return. Focus on companies that have high current profits and a reasonable chance of maintaining those profits. Buy your share of the business when it’s on sale. Enjoy outperforming the mutual funds that are simply speculating on short-term stock price movements (most of them).