Great Expectations

If last month was Roger Moore as 007, then we’re closing out this summer series with Michael Bay.  That’s right - it’s time for stock valuation, replete with explosions, special effects, and very confusing cuts in the action sequences. 

Stocks, also referred to as “equity”, are shares of ownership in a company.  These used to be issued as actual stock certificates (really decorative pieces of paper), but now it’s just digital 1’s and 0’s.  Kind of like the cash in your bank account. When you buy a stock, you expect to make money in two ways. One is by collecting a dividend (which right now averages just under 2% for the S&P 500).  The other is by the stock price going up.

Unlike bonds, there is no intrinsic starting point for stock valuation.  There is neither a maturity date nor a future value, which makes them more or less impossible to actually value.  Not kidding - there are textbooks upon textbooks upon college courses upon certifications all trying to impart some standardization to stock valuation.  But that uncertainty is also where the fireworks come in, and why stocks swing they way they do.

Step 1 - Objectively: You can force a time value of money framework on to stocks with some kind of cash flow model.  Most stocks pay a dividend, so theoretically the value of the stock should be the sum of all future dividend payments out to infinity discounted back to present value at the required rate of return minus the growth rate of the dividend.  Unfortunately, this requires an assumption that stretches literally OUT TO INFINITY and is zero help if the company doesn’t pay a dividend or has negative cash flow (Amazon, Netflix, Tesla, Uber, etc.)

Step 2 - Subjectively: The other thing you can do is look at ratios of the stock price to some fundamental metric.  Earnings are the most common metric (giving the ubiquitous P/E ratios), but you can use pretty much anything.  No assumptions needed for this one, but the ratio in and of itself is meaningless; you need to put it into context.  How does it compare to other companies in the industry? How does it compare to itself over the last few years?

Step 3 - Clark Gable: Or perhaps in this case it should be “Step 3 - Michael Bay.”  What steps 1 and 2 tell us is that stock prices are based on expectations of future earnings.  It’s changes in those expectations that cause the fireworks you see in the stock market.

Say the Beachcomber is a public company and is expected to have earnings of $1 per share next year, and let’s say it trades at 27 times earnings (roughly what the market is trading at today).  That means the price of one Beachcomber share right now is $27. Say because of the trade war, the cost of ink is going up this summer, meaning earnings next year will instead be $0.80 per share.  The stock is now worth $21.6 and lost 20% in the blink of an eye. And if the broader economy falls into recession, maybe investors are only willing to pay 20 times earnings instead of 27. So now your stock is only $16, sorry about that 41% you lost.

Stock valuation is not about “what is the correct price for this stock”.  Instead, stock valuation tries to answer some form of the question “am I getting a good deal”.  And at the moment, the answer is about 4-5% annually over the long-term. Whether or not that’s a good deal I will leave up to you.