John Burr Williams
Encyclopedia
John Burr Williams one of the first economist
s to view stock prices as determined by “intrinsic value
”, is recognised as a founder and developer of fundamental analysis
. He is best known for his 1938 text "The Theory of Investment Value", based on his Ph.D. thesis, which was amongst the first to articulate the theory
of Discounted Cash Flow
(DCF) based valuation, and in particular, dividend
based valuation.
and chemistry
at Harvard University
, and enrolled at Harvard Business School
in 1923. After graduating, he worked as a security analyst
, where he realised that "how to estimate the fair value
was a puzzle indeed... To be a good investment analyst, one needs to be an expert economist
also." In 1932 he enrolled at Harvard for a Ph.D.
in economics
, with the hopes of learning what had caused the Wall Street Crash of 1929
and the subsequent economic depression of the 1930s
. For his thesis, Joseph Schumpeter
suggested the question of the intrinsic value
of a common stock
, for which Williams' personal experience and background would serve him in good stead. He received his doctorate in 1940.
Williams sent The Theory of Investment Value for publication before he had won faculty approval for his doctorate. The work discusses Williams' general theory, as well as providing over 20 specific mathematical model
s; it also contains a second section devoted to case studies. Various publishers refused the work since it contained algebraic symbols
, and Harvard University Press
published The Theory of Investment Value in 1938, only after Williams had agreed to pay part of the printing cost. The work has been influential since its publication; Mark Rubinstein
describes it as an "insufficiently appreciated classic".
From 1927 until his death, Williams worked in the management
of private investment portfolios and security analysis
. He taught economics and investment analysis as a visiting professor at the University of Wisconsin–Madison
; he also wrote many articles for economic journals.
" view that economists held of financial markets and asset pricing—where prices are determined largely by expectations and counter-expectations of capital gains (see Keynesian beauty contest
). He argued that financial markets are, instead, "markets", properly speaking, and that prices should therefore reflect an asset's intrinsic value
. (Theory of Investment Value opens with: "Separate and distinct things not to be confused, as every thoughtful investor knows, are real worth and market price...".) In so doing, he changed the focus from the time series of the market to the underlying components of asset value. Rather than forecasting stock prices directly, Williams emphasized future corporate earnings and dividends.
Developing this idea, Williams proposed that the value of an asset should be calculated using “evaluation by the rule of present worth”. Thus, for a common stock
, the intrinsic, long-term worth is the present value
of its future net cash flows—in the form of dividend
distributions and selling price. Under conditions of certainty, the value of a stock is, therefore, the discounted value of all its future dividends; see Gordon model
.
While Williams did not originate the idea of present value
, he substantiated the concept of discounted cash flow valuation
and is generally regarded as having developed the basis for the dividend discount model
(DDM). Through his approach to modelling and forecasting cash flow
s—which he called “algebraic budgeting”—Williams was also a pioneer of the pro forma modeling of financial statement
s. Here, Williams (Theory, ch. 7) provides an early discussion of industry lifecycle.
Today, “evaluation by the rule of present worth”, applied in conjunction with an asset appropriate discount rate — usually derived using the capital asset pricing model
of modern portfolio theory
(Harry Markowitz
and William Sharpe
), or the arbitrage pricing theory
(Stephen Ross
) — is probably the most widely used stock valuation
method amongst institutional investor
s; see List of valuation topics. (Nicholas Molodovsky, the former editor of the Financial Analysts Journal, was the first to substitute "dividends" in Williams' formula for: earnings times the percentage of earnings paid out in dividends.)
Williams also anticipated the Modigliani-Miller theorem
. In presenting the "Law of the Conservation of Investment Value" (Theory, pg. 72), he argued that since the value of an enterprise is the "present worth" of all its future distributions - whether interest
or dividend
s - it "in no [way] depends on what the company’s capitalization is". Modigliani
and Miller
show that Williams, however, had not actually proved
this law, as he had not made it clear how an arbitrage
opportunity would arise if his Law were to fail.
In context
Models
Economist
An economist is a professional in the social science discipline of economics. The individual may also study, develop, and apply theories and concepts from economics and write about economic policy...
s to view stock prices as determined by “intrinsic value
Intrinsic value (finance)
In finance, intrinsic value refers to the value of a security which is intrinsic to or contained in the security itself. It is also frequently called fundamental value. It is ordinarily calculated by summing the future income generated by the asset, and discounting it to the present value...
”, is recognised as a founder and developer of fundamental analysis
Fundamental analysis
Fundamental analysis of a business involves analyzing its financial statements and health, its management and competitive advantages, and its competitors and markets. When applied to futures and forex, it focuses on the overall state of the economy, interest rates, production, earnings, and...
. He is best known for his 1938 text "The Theory of Investment Value", based on his Ph.D. thesis, which was amongst the first to articulate the theory
Theory
The English word theory was derived from a technical term in Ancient Greek philosophy. The word theoria, , meant "a looking at, viewing, beholding", and referring to contemplation or speculation, as opposed to action...
of Discounted Cash Flow
Discounted cash flow
In finance, discounted cash flow analysis is a method of valuing a project, company, or asset using the concepts of the time value of money...
(DCF) based valuation, and in particular, dividend
Dividend
Dividends are payments made by a corporation to its shareholder members. It is the portion of corporate profits paid out to stockholders. When a corporation earns a profit or surplus, that money can be put to two uses: it can either be re-invested in the business , or it can be distributed to...
based valuation.
Biography
Williams studied mathematicsMathematics
Mathematics is the study of quantity, space, structure, and change. Mathematicians seek out patterns and formulate new conjectures. Mathematicians resolve the truth or falsity of conjectures by mathematical proofs, which are arguments sufficient to convince other mathematicians of their validity...
and chemistry
Chemistry
Chemistry is the science of matter, especially its chemical reactions, but also its composition, structure and properties. Chemistry is concerned with atoms and their interactions with other atoms, and particularly with the properties of chemical bonds....
at Harvard University
Harvard University
Harvard University is a private Ivy League university located in Cambridge, Massachusetts, United States, established in 1636 by the Massachusetts legislature. Harvard is the oldest institution of higher learning in the United States and the first corporation chartered in the country...
, and enrolled at Harvard Business School
Harvard Business School
Harvard Business School is the graduate business school of Harvard University in Boston, Massachusetts, United States and is widely recognized as one of the top business schools in the world. The school offers the world's largest full-time MBA program, doctoral programs, and many executive...
in 1923. After graduating, he worked as a security analyst
Financial analyst
A financial analyst, securities analyst, research analyst, equity analyst, or investment analyst is a person who performs financial analysis for external or internal clients as a core part of the job.-Job:...
, where he realised that "how to estimate the fair value
Fair value
Fair value, also called fair price , is a concept used in accounting and economics, defined as a rational and unbiased estimate of the potential market price of a good, service, or asset, taking into account such objective factors as:* acquisition/production/distribution costs, replacement costs,...
was a puzzle indeed... To be a good investment analyst, one needs to be an expert economist
Economist
An economist is a professional in the social science discipline of economics. The individual may also study, develop, and apply theories and concepts from economics and write about economic policy...
also." In 1932 he enrolled at Harvard for a Ph.D.
Ph.D.
A Ph.D. is a Doctor of Philosophy, an academic degree.Ph.D. may also refer to:* Ph.D. , a 1980s British group*Piled Higher and Deeper, a web comic strip*PhD: Phantasy Degree, a Korean comic series* PhD Docbook renderer, an XML renderer...
in economics
Economics
Economics is the social science that analyzes the production, distribution, and consumption of goods and services. The term economics comes from the Ancient Greek from + , hence "rules of the house"...
, with the hopes of learning what had caused the Wall Street Crash of 1929
Wall Street Crash of 1929
The Wall Street Crash of 1929 , also known as the Great Crash, and the Stock Market Crash of 1929, was the most devastating stock market crash in the history of the United States, taking into consideration the full extent and duration of its fallout...
and the subsequent economic depression of the 1930s
Great Depression
The Great Depression was a severe worldwide economic depression in the decade preceding World War II. The timing of the Great Depression varied across nations, but in most countries it started in about 1929 and lasted until the late 1930s or early 1940s...
. For his thesis, Joseph Schumpeter
Joseph Schumpeter
Joseph Alois Schumpeter was an Austrian-Hungarian-American economist and political scientist. He popularized the term "creative destruction" in economics.-Life:...
suggested the question of the intrinsic value
Intrinsic value
Intrinsic value can refer to:*Intrinsic value , of an option or stock.*Intrinsic value , of a coin.*Intrinsic value , in ethics and philosophy.*Intrinsic value , in philosophy....
of a common stock
Common stock
Common stock is a form of corporate equity ownership, a type of security. It is called "common" to distinguish it from preferred stock. In the event of bankruptcy, common stock investors receive their funds after preferred stock holders, bondholders, creditors, etc...
, for which Williams' personal experience and background would serve him in good stead. He received his doctorate in 1940.
Williams sent The Theory of Investment Value for publication before he had won faculty approval for his doctorate. The work discusses Williams' general theory, as well as providing over 20 specific mathematical model
Mathematical model
A mathematical model is a description of a system using mathematical concepts and language. The process of developing a mathematical model is termed mathematical modeling. Mathematical models are used not only in the natural sciences and engineering disciplines A mathematical model is a...
s; it also contains a second section devoted to case studies. Various publishers refused the work since it contained algebraic symbols
Elementary algebra
Elementary algebra is a fundamental and relatively basic form of algebra taught to students who are presumed to have little or no formal knowledge of mathematics beyond arithmetic. It is typically taught in secondary school under the term algebra. The major difference between algebra and...
, and Harvard University Press
Harvard University Press
Harvard University Press is a publishing house established on January 13, 1913, as a division of Harvard University, and focused on academic publishing. In 2005, it published 220 new titles. It is a member of the Association of American University Presses. Its current director is William P...
published The Theory of Investment Value in 1938, only after Williams had agreed to pay part of the printing cost. The work has been influential since its publication; Mark Rubinstein
Mark Rubinstein
Mark Edward Rubinstein is a leading financial economist and financial engineer. He is currently Professor of Finance at the Haas School of Business of the University of California, Berkeley, where he is involved in teaching courses in the , an academic program that is focused on equipping...
describes it as an "insufficiently appreciated classic".
From 1927 until his death, Williams worked in the management
Investment management
Investment management is the professional management of various securities and assets in order to meet specified investment goals for the benefit of the investors...
of private investment portfolios and security analysis
Security analysis
Security analysis is the analysis of tradeable financial instruments called securities. These can be classified into debt securities, equities, or some hybrid of the two. More broadly, futures contracts and tradeable credit derivatives are sometimes included...
. He taught economics and investment analysis as a visiting professor at the University of Wisconsin–Madison
University of Wisconsin–Madison
The University of Wisconsin–Madison is a public research university located in Madison, Wisconsin, United States. Founded in 1848, UW–Madison is the flagship campus of the University of Wisconsin System. It became a land-grant institution in 1866...
; he also wrote many articles for economic journals.
Theory
Williams was among the first to challenge the "casinoCasino
In modern English, a casino is a facility which houses and accommodates certain types of gambling activities. Casinos are most commonly built near or combined with hotels, restaurants, retail shopping, cruise ships or other tourist attractions...
" view that economists held of financial markets and asset pricing—where prices are determined largely by expectations and counter-expectations of capital gains (see Keynesian beauty contest
Keynesian beauty contest
A Keynesian beauty contest is a concept developed by John Maynard Keynes and introduced in Chapter 12 of his work, General Theory of Employment Interest and Money , to explain price fluctuations in equity markets.-Overview:...
). He argued that financial markets are, instead, "markets", properly speaking, and that prices should therefore reflect an asset's intrinsic value
Intrinsic value (finance)
In finance, intrinsic value refers to the value of a security which is intrinsic to or contained in the security itself. It is also frequently called fundamental value. It is ordinarily calculated by summing the future income generated by the asset, and discounting it to the present value...
. (Theory of Investment Value opens with: "Separate and distinct things not to be confused, as every thoughtful investor knows, are real worth and market price...".) In so doing, he changed the focus from the time series of the market to the underlying components of asset value. Rather than forecasting stock prices directly, Williams emphasized future corporate earnings and dividends.
Developing this idea, Williams proposed that the value of an asset should be calculated using “evaluation by the rule of present worth”. Thus, for a common stock
Common stock
Common stock is a form of corporate equity ownership, a type of security. It is called "common" to distinguish it from preferred stock. In the event of bankruptcy, common stock investors receive their funds after preferred stock holders, bondholders, creditors, etc...
, the intrinsic, long-term worth is the present value
Present value
Present value, also known as present discounted value, is the value on a given date of a future payment or series of future payments, discounted to reflect the time value of money and other factors such as investment risk...
of its future net cash flows—in the form of dividend
Dividend
Dividends are payments made by a corporation to its shareholder members. It is the portion of corporate profits paid out to stockholders. When a corporation earns a profit or surplus, that money can be put to two uses: it can either be re-invested in the business , or it can be distributed to...
distributions and selling price. Under conditions of certainty, the value of a stock is, therefore, the discounted value of all its future dividends; see Gordon model
Gordon model
The Gordon growth model is a variant of the discounted cash flow model, a method for valuing a stock or business. Often used to provide difficult-to-resolve valuation issues for litigation, tax planning, and business transactions that don't have an explicit market value. It is named after Myron J....
.
While Williams did not originate the idea of present value
Present value
Present value, also known as present discounted value, is the value on a given date of a future payment or series of future payments, discounted to reflect the time value of money and other factors such as investment risk...
, he substantiated the concept of discounted cash flow valuation
Valuation using discounted cash flows
Valuation using discounted cash flows is a method for determining the current value of a company using future cash flows adjusted for time value. The future cash flow set is made up of the cash flows within the determined forecast period and a continuing value that represents the cash flow stream...
and is generally regarded as having developed the basis for the dividend discount model
Dividend Discount Model
The dividend discount model is a way of valuing a company based on the theory that a stock is worth the discounted sum of all of its future dividend payments. In other words, it is used to evaluate stocks based on the net present value of the future dividends. Dividend discount model is a tool...
(DDM). Through his approach to modelling and forecasting cash flow
Cash flow
Cash flow is the movement of money into or out of a business, project, or financial product. It is usually measured during a specified, finite period of time. Measurement of cash flow can be used for calculating other parameters that give information on a company's value and situation.Cash flow...
s—which he called “algebraic budgeting”—Williams was also a pioneer of the pro forma modeling of financial statement
Financial statement
A financial statement is a formal record of the financial activities of a business, person, or other entity. In British English—including United Kingdom company law—a financial statement is often referred to as an account, although the term financial statement is also used, particularly by...
s. Here, Williams (Theory, ch. 7) provides an early discussion of industry lifecycle.
Today, “evaluation by the rule of present worth”, applied in conjunction with an asset appropriate discount rate — usually derived using the capital asset pricing model
Capital asset pricing model
In finance, the capital asset pricing model is used to determine a theoretically appropriate required rate of return of an asset, if that asset is to be added to an already well-diversified portfolio, given that asset's non-diversifiable risk...
of modern portfolio theory
Modern portfolio theory
Modern portfolio theory is a theory of investment which attempts to maximize portfolio expected return for a given amount of portfolio risk, or equivalently minimize risk for a given level of expected return, by carefully choosing the proportions of various assets...
(Harry Markowitz
Harry Markowitz
Harry Max Markowitz is an American economist and a recipient of the John von Neumann Theory Prize and the Nobel Memorial Prize in Economic Sciences....
and William Sharpe
William Forsyth Sharpe
William Forsyth Sharpe is the STANCO 25 Professor of Finance, Emeritus at Stanford University's Graduate School of Business and the winner of the 1990 Nobel Memorial Prize in Economic Sciences....
), or the arbitrage pricing theory
Arbitrage pricing theory
In finance, arbitrage pricing theory is a general theory of asset pricing that holds that the expected return of a financial asset can be modeled as a linear function of various macro-economic factors or theoretical market indices, where sensitivity to changes in each factor is represented by a...
(Stephen Ross
Stephen Ross (economist)
Stephen Alan "Steve" Ross is the inaugural Franco Modigliani Professor of Financial Economics at the MIT Sloan School of Management. He is known for initiating several important theories and models in financial economics...
) — is probably the most widely used stock valuation
Stock valuation
In financial markets, stock valuation is the method of calculating theoretical values of companies and their stocks. The main use of these methods is to predict future market prices, or more generally potential market prices, and thus to profit from price movement – stocks that are judged...
method amongst institutional investor
Institutional investor
Institutional investors are organizations which pool large sums of money and invest those sums in securities, real property and other investment assets...
s; see List of valuation topics. (Nicholas Molodovsky, the former editor of the Financial Analysts Journal, was the first to substitute "dividends" in Williams' formula for: earnings times the percentage of earnings paid out in dividends.)
Williams also anticipated the Modigliani-Miller theorem
Modigliani-Miller theorem
The Modigliani–Miller theorem forms the basis for modern thinking on capital structure. The basic theorem states that, under a certain market price process , in the absence of taxes, bankruptcy costs, agency costs, and asymmetric information, and in an efficient market, the value of a firm is...
. In presenting the "Law of the Conservation of Investment Value" (Theory, pg. 72), he argued that since the value of an enterprise is the "present worth" of all its future distributions - whether interest
Interest
Interest is a fee paid by a borrower of assets to the owner as a form of compensation for the use of the assets. It is most commonly the price paid for the use of borrowed money, or money earned by deposited funds....
or dividend
Dividend
Dividends are payments made by a corporation to its shareholder members. It is the portion of corporate profits paid out to stockholders. When a corporation earns a profit or surplus, that money can be put to two uses: it can either be re-invested in the business , or it can be distributed to...
s - it "in no [way] depends on what the company’s capitalization is". Modigliani
Franco Modigliani
Franco Modigliani was an Italian economist at the MIT Sloan School of Management and MIT Department of Economics, and winner of the Nobel Memorial Prize in Economics in 1985.-Life and career:...
and Miller
Merton Miller
Merton Howard Miller was the co-author of the Modigliani-Miller theorem which proposed the irrelevance of debt-equity structure. He shared the Nobel Memorial Prize in Economic Sciences in 1990, along with Harry Markowitz and William Sharpe...
show that Williams, however, had not actually proved
Evidence (law)
The law of evidence encompasses the rules and legal principles that govern the proof of facts in a legal proceeding. These rules determine what evidence can be considered by the trier of fact in reaching its decision and, sometimes, the weight that may be given to that evidence...
this law, as he had not made it clear how an arbitrage
Arbitrage
In economics and finance, arbitrage is the practice of taking advantage of a price difference between two or more markets: striking a combination of matching deals that capitalize upon the imbalance, the profit being the difference between the market prices...
opportunity would arise if his Law were to fail.
Publications
- The Theory of Investment Value. Harvard University Press 1938; 1997 reprint, Fraser Publishing. ISBN 0-87034-126-X
- International trade under flexible exchange rates. 1954
- Interest, Growth & Inflation 1964; 1998 reprint, Fraser Publishing. ISBN 0-87034-131-6
See also
- Benjamin GrahamBenjamin GrahamBenjamin Graham was an American economist and professional investor. Graham is considered the first proponent of value investing, an investment approach he began teaching at Columbia Business School in 1928 and subsequently refined with David Dodd through various editions of their famous book...
- Irving FisherIrving FisherIrving Fisher was an American economist, inventor, and health campaigner, and one of the earliest American neoclassical economists, though his later work on debt deflation often regarded as belonging instead to the Post-Keynesian school.Fisher made important contributions to utility theory and...
- Philip FisherPhilip Arthur FisherPhilip Arthur Fisher was an American stock investor best known as the author of Common Stocks and Uncommon Profits, a guide to investing that has remained in print ever since it was first published in 1958. Fisher studied business at Stanford University...
- Gordon modelGordon modelThe Gordon growth model is a variant of the discounted cash flow model, a method for valuing a stock or business. Often used to provide difficult-to-resolve valuation issues for litigation, tax planning, and business transactions that don't have an explicit market value. It is named after Myron J....
- Value investingValue investingValue investing is an investment paradigm that derives from the ideas on investment and speculation that Ben Graham and David Dodd began teaching at Columbia Business School in 1928 and subsequently developed in their 1934 text Security Analysis...
- Intrinsic theory of valueIntrinsic theory of valueAn intrinsic theory of value is any theory of value in economics which holds that the value of an object, good or service, is intrinsic or contained in the item itself...
- Corporate finance: The investment decision
External links
John Burr Williams- Theory of Investment Value, fraserpublishing.com
- John Burr Williams, The Theory of Investment Value, numeraire.com
- Obituary, NY Times
- John Burr Williams on dividends, beginnersinvest, about.comAbout.comAbout.com is an online source for original information and advice. It is written in English, and is aimed primarily at North Americans. It is owned by The New York Times Company....
In context
- Capital Ideas: The Improbable Origins of Modern Wall Street, Peter L. BernsteinPeter L. BernsteinPeter Lewyn Bernstein was an American financial historian, economist and educator whose development and refinement of the efficient-market hypothesis made him one of the country's best known authorities in popularizing and presenting investment economics to the general public.-Education and...
. Free Press 1993. ISBN 0-02-903012-9 - Finance Theory, The History of Economic Thought Website, The New SchoolThe New SchoolThe New School is a university in New York City, located mostly in Greenwich Village. From its founding in 1919 by progressive New York academics, and for most of its history, the university was known as the New School for Social Research. Between 1997 and 2005 it was known as New School University...
- A Short History of Investment Forecasting, Prof. Michael Phillips, California State University, NorthridgeCalifornia State University, NorthridgeCalifornia State University, Northridge is a public university in Northridge, a neighborhood in the San Fernando Valley area of Los Angeles, California, United States....
- Great Moments in Financial Economics I, II, Prof. Mark RubinsteinMark RubinsteinMark Edward Rubinstein is a leading financial economist and financial engineer. He is currently Professor of Finance at the Haas School of Business of the University of California, Berkeley, where he is involved in teaching courses in the , an academic program that is focused on equipping...
, Haas School of BusinessHaas School of BusinessThe Walter A. Haas School of Business, also known as the Haas School of Business or simply Haas, is one of 14 schools and colleges at the University of California, Berkeley.... - The Scientific Evolution of Finance, Prof. Don Chance, Louisiana State UniversityLouisiana State UniversityLouisiana State University and Agricultural and Mechanical College, most often referred to as Louisiana State University, or LSU, is a public coeducational university located in Baton Rouge, Louisiana. The University was founded in 1853 in what is now known as Pineville, Louisiana, under the name...
; Prof. Pamela Peterson James Madison UniversityJames Madison UniversityJames Madison University is a public coeducational research university located in Harrisonburg, Virginia, U.S. Founded in 1908 as the State Normal and Industrial School for Women at Harrisonburg, the university has undergone four name changes before settling with James Madison University... - Selected Moments in the History of Discounted Present Value, Prof. Eric Kirzner Rotman School of ManagementRotman School of ManagementThe Joseph L. Rotman School of Management commonly known as Rotman School of Management is the University of Toronto's business school, located in St. George Street in Downtown Toronto. The school, named after Joseph L...
Models
- Dividend Discount Model, moneychimp.com
- Stock Valuation using John Burr Williams Formula, capital-flow-analysis.com