“There seems to be some perverse human characteristic that likes to make easy things difficult.”

“If you understand an idea, you can express it so that others can understand it.”

Warren Buffett The Tao of Warren Buffett

The 2nd Most Powerful Formula in Finance

As individual investors we must learn to dance between the legs of elephants. As managers, we must learn how to avoid being distracted by random market events so that we can focus on our primary role of creating Enterprise Value. The 2nd Most Powerful Formula in Finance explains how stock price is affected by the actions that managers take to create (or destroy) Enterprise Value and the actions that Shareowners take on their own behalf to create (or destroy) value for themselves. The following simple spreadsheet reveals the power of the 2nd Most Powerful Formula in Finance to explain stock price, responsibility and accountability.

Stock Price	=	Enterprise Value per share	+	Supply & Demand for the Stock
Creation of Shareowner Value: Management vs. Shareowner The Shareowner’s return is earned by the difference between the price at which he buys and sells the stock – plus dividends.		Responsibility of Management Management controls the creation (or destruction) of free cash flow in a company as well as the company’s cost of capital (Determined by the amount of debt vs equity that the company uses.) These are the two factors that create (or destroy) Enterprise Value.		Responsibility of Individual Shareowners Shareowners control the price at which they individually buy or sell a stock. The Shareowner’s objective is to buy stock below Enterprise Value and to sell stock at a price above Enterprise Value.
Rate of Change:		Enterprise Value changes slowly over time because it is driven by changes in free cash flow resulting from the company’s operations.		Supply and demand is volatile because any number of transient events, ranging from company or industry specific to world events, affects it.
Stock Analysis: Fundamental vs. Technical		Fundamental Analysis In stock investing, calculating the Enterprise Value (using research into cash flows and expected growth rates) is known as fundamental analysis.		Technical Analysis In stock investing, using the price and volume movements of a stock to determine buy and sell points is known as technical analysis.
Stock Price Movement		50 Percent of the Stock Price Movement Data shows that at least 50 percent of stock price movement is correlated with changes in Economic Profit, a proxy for Enterprise Value.		50 Percent of the Stock Price Movement The implication is that 50 percent of stock price movement is due to various supply & demand factors.
Value Creation vs. Wealth Transfer		Creates Economic Value for Shareowners and Society A company that earns more than its cost of capital is using its capital effectively. Therefore, it is creating economic value for society.		Transfers Economic Value between the old and new Shareowners Transferring wealth between people creates no new economic value for society other than a marginal value produced by the liquidity factor. (AS the 2008 sub-prime liquidity crisis demonstrated, liquidity is essential to the functioning of financial markets. BUT liquidity does not create value. It merely permits the transfer of whatever value exists in the underlying security.