What drives the value of a stock?
When someone gets behind the wheel of a car for a long drive, whether they realize it or not, they are conducting a valuation exercise. This is because their speed is discretionary, and there are costs and benefits to the speed chosen. While speed limits vary by state and situation, generally speaking, all drivers have the choice to break the speed limit and by how much. On the one hand, some prefer to keep the speedometer strictly at the limit (and that’s fine, as long as they stay in the lane to the right). On the other hand, it’s unrealistic to think one can exceed the limit by 40 mph the entire journey without receiving a ticket.
So the decision centers on the probability of a speeding ticket and the magnitude of the ticket in dollars, relative to how each additional mph increase impacts the time saved. Obviously, this process is imprecise. Apart from the natural uncertainties, such as a cop’s demeanor or local speeding tolerances, there are longer-term financial uncertainties such as the impact on insurance rates. Therefore, many “play it safe” by going approximately 10 mph over the limit because that is an acceptable risk. These are the cost-benefit decisions people make on a daily basis. But what about similar judgments in their investment portfolio?
The Art of Valuation
Compare this to the valuation of a stock, which also focuses on the most easily obtained data and works in the majority of situations but carries with it a great deal of uncertainty. Just as a cop, unbeknownst to the driver, might need to meet a month-end quota or local ordinances might compel the officer to pull the driver over, a stock might carry with it idiosyncratic risks unseen to the investor. An unexpected increase in insurance rates could sting a lot worse than expected, as could a sudden decline in company sales.
It is for these reasons that valuation is more art than science. Though it may seem to be scientific because it employs numbers and complex models, those things are not valuation themselves. A person must interpret the numbers, and a person must build the model. And these people, quite obviously, are human and subject to human behavior biases. Perhaps more worrisome is that many of the numbers in a model are nothing more than a person’s educated guesses about the future, thus introducing uncertainty into the model. As typically utilized, these guesses are completely at the discretion of the analyst.
This is the crux of the problem. When an analyst approaches a valuation, he or she will almost always have bias, whether they know it or not, towards having the model reach a certain conclusion. The stock investor wants to find stocks to buy, so the natural tendency is to be optimistic about the company’s prospects. In more egregious situations, the investment banker has a monetary incentive, perhaps, to reach a valuation that supports the deal he or she is working on.
Consider a typical discounted cash flow (DCF) valuation. In a conventional DCF, the analyst will carefully calculate the discount rate, (even though it can be easily manipulated), project future cash flows, (even though they are merely guesses), and decide upon a terminal growth rate, (even though only slight changes in it can have a huge impact on the output of the model). Between these three discretionary components of a DCF model, the analyst largely has the ability to reach any conclusion he or she should desire. This may happen deliberately, as in the case of the investment banker trying to close a deal, or subconsciously, as in the case of the investor desperate for a stock to buy. Saying this process involves some imprecision may in fact be generous.
The imprecision that comes with DCF valuation largely centers around growth. Simply adjusting assumptions about future growth can allow the analyst to reach wildly different conclusions. Perhaps, then, the goal should not be to best predict the future but rather avoid predicting it – or making any other unnecessary assumptions – and focus on what does not have to be guessed.
Different Road, Same Destination
Of course, other approaches to valuation abound as well. These can usually be classified as “relative” valuation techniques and involve the use of ratios such as price-to-earnings, price-to-EBITDA, price-to-sales, and so forth. Unfortunately, the problems with relative valuation include all of the problems of DCF valuation and then some. In reality, relative valuation is simply a shortcut to DCF valuation but introduces even more imprecision. In using the ratios – sometimes called multiples – of peer companies to infer what type of ratio is appropriate for the company being valued, the analyst is impounding a tremendous amount of bias regarding how favorably or unfavorably the company compares to its peers. If the analyst likes the company, he or she will want to assign it a higher multiple. That is the danger.
Giving in to biases when performing a valuation is often inescapable because it is, typically, more art than science. The secret to better valuation, therefore, is to remove the artistic component. Rather than guessing about the future, use discretion and rely on what is known.
There is a better way.
When conducting valuation, it is imperative to remember the enormous amount of uncertainty but also the bias that comes from the human conducting it. This is because, when an analyst is biased, consciously or subconsciously, the variables driving the output become more subject to the analyst’s opinion and less accurate. The key, therefore, is to avoid bias, avoid human behavior and focus on what is known.
What do we know for sure? One thing that is known with complete precision is the stock price. We observe it and can watch it change continuously in real-time. But stock prices are not arbitrary. They all have meaning, and the most important meaning they have is the growth that each stock price implies. Thus, by focusing on this one piece of precise information, the stock price, and solving for what would otherwise need to be assumed, the growth rate, we can circumvent nearly all the problems mentioned above.
Value judgments are a part of life. Each of us has the option to honk at the slowpoke in the left lane or to go 20 MPH over the speed limit because we’re in a hurry. But we also have to be prepared for the consequences. Judgments should have no place in valuation, however. The value of a security should be determined via an actuarial process that strips out any and all vague and ambiguous information. If not, the speedometer on your investment portfolio might be notching much slower gains than you anticipated.
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