Stock Market Values (Part 1)

How much is a stock worth?

Deutsche Bourse. Source: Wikipedia

The short answer is, whatever someone is willing to pay. But what should they pay—what’s fair? There’s lots of ways to answer that question. The most fundamental approach is to calculate all the cash flows that an investor expects to receive in the future, discount these to their present value, and add them up. The total is the “fair” value: the discounted sum of all the future cash flows.

But there are two problems: determining how much cash the business will generate, and figuring what discount rate to use. Also, we don’t know how willing and able management will be to return cash to the shareholders. Analysts need to guess when a non-dividend paying stock will start. For example, Apple didn’t begin paying dividends until after Steve Jobs died.

So investors use shortcuts to estimate value, ratios such as price-to-book, price-to-sales, or the price-earnings ratio—dividing the market cap of the company by an historical accounting metric. The challenge with these approaches is that they do not account for growth or risk. Also, it’s difficult to use earnings-based ratios when a company is losing money, either because of cyclical issues or because they are at an early stage in their life cycle. Finally, while the formulas calculate a ratio, they don’t tell us what that ratio should be. Looking at historical averages can be misleading when circumstances change.

So some analysts use multivariate models that take into account earnings, dividends, growth, balance sheet factors, cash flow, and other variables. These approaches create an estimate of fair value that can be compared with individual equity prices or even the entire market. What the models gain in subtlety, however, they give up in transparency. Complex design becomes a black box, that people treat like a “Magic 8-Ball.” Blind adherence this approach can lead investors to do foolish things—like ploughing money into bank stocks at the beginning of the Financial Crisis. Those companies’ historical performance did not reflect the current economic conditions.

Pricing Optimization Model. Source: Mathworks

In the end, any model is only as good as its inputs. The old dictum of “garbage in, garbage out” applies especially to equity valuation. Many companies have been able to deceive analysts for years by gaming the accounting rules—Enron, Lehman, Tyco, AIG. Eventually, however, the truth comes out. You can’t fool all the models all the time. But investors who owned these stocks lost billions.

We need remember what the statistician George Box observed when he wrote, “Essentially, all models are wrong, but some models are useful.”

Douglas R. Tengdin, CFA

Chief Investment Officer

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