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

By | 2017-07-17T12:21:58+00:00 May 11th, 2016|Global Market Update|0 Comments

About the Author:

Mr. Tengdin is the Chief Investment Officer at Charter Trust Company and author of “The Global Market Update”. The audio version of each post can be heard on radio stations throughout New England every weekday. Mr. Tengdin graduated from Dartmouth College, Magna Cum Laude. He received his Master of Arts from Trinity Divinity School, Magna Cum Laude and received his Chartered Financial Analyst (CFA) designation in 1992. Mr. Tengdin has been managing investment portfolios for over 30 years, working for Bank of Boston, State Street Global Advisors, Citibank – Tunisia, and Banknorth Group. Throughout his career, Mr. Tengdin has emphasized helping clients manage their financial risks in difficult environments where they can profit from investing in diverse assets in diverse settings. - Leave a comment if you have any questions—I read them all! - And Follow me on Twitter @GlobalMarketUpd

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