The Corner Grocery Store
I have my own way of looking at stock valuation, but be warned, it is obvious the rest of the world does not agree with me. There is a difference, that I cannot fully explain because I don't understand it too well myself, in translating the valuation of a business to that of a publicly traded stock. Perhaps the following rough exercise in the various components of valuing a business as an investment will help us both in making that leap.
First let's start with the corner grocery store. It is for sale and I decide it might not be a bad idea to retire from Wall-Street and settle into a less stressful job (I would probably find that part not true). After talking to the owner and crunching some numbers, I determine that the business should throw off around $100,000 a year in cash after expenses and before taxes.
I also determine that there is little franchise value for the store: when I want to sell it, the future buyer will look at the investment much like I am looking at it (just cash flows) and since I won't be able to grow revenues much, I determine that the future buyer will probably pay around the same price. I look around and decide that the neighborhood does most of their small food shopping there and that won't change, so these numbers won't decline or grow much for the foreseeable future (volatility of earnings; risk).
In further analyzing the investment, I must decide what risk premium to use: I must decide what return I want to earn over the risk free rate (the rate at which I can invest my cash) to compensate me for the risk. Because I consider the risk fairly low of any problems in cash flow, I decide that I only need to earn 10% over the risk free rate of 2% over the next 20 years. Since the future value is the same as the present value, I simply must determine what price to pay to earn 12% given that I will make $100,000 per year over the next 20 years: discounting these cash flows at 12% over 20 years I come out with a present value of $747,000. I look at this number, which startles me a little, and decide to play with the numbers. Maybe the cash flows are a little riskier than I first assumed (effectively rationalizing why I should pay a lower price), so I up the risk premium and decide that I need 15% over the risk free rate: discounting the cash flows back at this rate gives me a present value of $562,000. Hmmm, that price is still a little too high for me, so next I decide that the business may not survive for 20 years, but only 10: discounting back for only 10 years gives me a price of $465,000. Since I am very comfortable with the assumptions now, I decide that this price is right.
Notice that because the time periods are long, a small change in my assumptions gave me a large change in the price I was willing to pay. The predominant variable is risk premium: what I demand in return for this investment and its risks over other investments and their risk. This is probably the variable that is debated the most among market participants and causes significant fluctuations in the stock market.
Some believe that, for instance, the risk premium versus bonds should be zero (those that wrote the book, "Dow 36,000") because stocks return more than bonds over long periods of time. I would argue that this has nothing to do with risk: stocks are at least twice as volatile as bonds and hence, investors can make more mistakes like selling for a loss.
Notice also that I changed my numbers to arrive at a price that I wanted to pay! What this should tell you is that human psychology (simply what people are willing to pay) plays the most significant part in driving stock prices. When markets get fundamentally overvalued, investors rationalize higher prices by taking more risk and vice versa when the market becomes undervalued. There is a fair value for a business determined by a company's cash flows, growth assumptions, and franchise value, but that value can vary widely because of other more general variables like general interest rates, the attractiveness of alternative investments, the amount of over-all money available, and most importantly, the risk premium.
Notice finally that in the above exercise I did not even use the P/E ratio explicitly; the P/E ratio is short-hand for discounting earnings (cash flows) over some time period. This variable in itself has been made incredibly complicated (perhaps deviously so) by Wall-Street. In Sunday's New York Times, Gretchen Morgenson reports that, "the quality of earnings for the S&P500, from an accounting standpoint is the worst it has been in more than a decade."
In moving from valuing a particular business to a publicly traded stock, several things happen that, quite frankly, I do not fully understand. First, the market assigns a franchise value automatically, sometimes twice what the company is worth as a private business. This may be due to its increased ability to raise capital or expand its business, but I think it has more to do with herd mentality and scarcity of stock. The market also assumes that the business is virtually perpetual in nature (remember discounting over a longer period of time increases the value), when we know that companies go out of business all the time (the average life a company that goes public may be as short as 10 to 15 years).
I do believe that one can fundamentally value a stock if one's assumptions are accurate. The irony is that those assumptions become less and less clear the farther out in time you go. But I also believe that the fundamental value is completely overwhelmed by the softer factors that drive stock prices. This is the primary reason that I trade volatility.
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