Value Investing's Golden Rule: Whirlpool, GE

Here's the longer version, applied to the Whirlpool example above: Absent a material change to the business (there has been no impairment to Whirlpool's value), as price declines (the price drops from $90 to $60), risk declines (risk declines because the gap between price and value increases), and your anticipated rate of return increases (selling Whirlpool is dumb, because your capital increases 100% if you hold the stock from a $60 quote until you can get full value, or $120).

To understand the formula better, let's take it apart, piece by piece:

The Qualifier

Absent a material change to the business...

When there is a material change to the business, sufficient to impair the underlying value, the formula does not apply. Here are a few examples of a material change: a permanent loss of market share, product obsolescence and a reduction of profit expectations over the long term.

The current imbroglio surrounding financial companies is a material change, and it requires a valuation adjustment. For example, owners of Citigroup (C Quote), Lehman Brothers (LEH Quote) and Washington Mutual (WM Quote), among many others, have suffered equity dilution while, at the same, time, billions of dollars of assets have disappeared from their balance sheets.

What about the recession? Does a recession constitute a material change, sufficient to warrant a diminished business valuation? The answer is, generally, no. A cyclical pullback in the economy does not affect the long-term value of most businesses. That's because smart analysts already factor cyclical pullbacks into their valuation analysis.

The fact that Whirlpool is struggling with a cyclical decline in demand is no big surprise. Not only is the current cycle not a surprise, but skilled analysts will build at least one more difficult cycle into their model for the next 10 years.

Price

As price declines...

If your neighbor offers you one-half of the value for your car, you'll probably laugh it off. If a stranger parades into your family-owned business and offers you one-half of value, you might roll your eyes or shake your head. You might even be offended. That's because you see these offers for what they are: nonsense.