MONTHLY THINKERINGS: Business Valuations and Stock Prices February 1, 2010Posted by huymix in Business, Monthly Thinkerings.
Tags: Business Valuation, Future cash flows, Jim Kramer, lump sum, Mad Money, share prices, Stock Market
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Before I go on, I’ll break this up into 2 parts: Business Valuations; and Stock Prices.
A general principle of business valuation is that the value of a business is the discounted future cash flows of a company. So, if you estimate that the company is going to get say $1 M for 10 years you can put a price on that to someone who wants to receive $1 M for 10 years. Instead of getting $10 M over 10 years, maybe you get $6 M today instead. We see these types of discounting particularly in lotteries where they present the option of taking the full $ value or the “lump sum”. Lump sum is the same, more easy to understand, term for the $ 6 M in my example.This is in a very general sense the way businesses are valued.
What is wrong with the above scenario? In a perfect world, nothing, in the real world:
- Estimate Certainty. Future cash flows are guesses at best. If we could somehow guarantee $1 M per year that’s a whole different story. A business’ ability to get that cash is based on their ability to draw enough customers and to be profitable. Even companies with smart manager’s, a good product, and a strong customer base cannot guarantee their future cash flows because the world acts in unpredictable ways.
- Length of Estimates. A lot of the time, the value is discounted for extremely long times or even infinite (if you’re using a multiplier than that is across infinite). So not only does a business valuation rest on guesses, it’s relying on guessing into the far future. These cash flows have a built in assumption of predictability. If you asked AOL in 1995 how their cash flows would look in 2010, and compared them to actual, I’m sure you would be surprised at how differently the world and the business environment changes.
- Actual Cash Flow. There is the problem that the idea that a company is generating a lot of cash and that money should eventually flow to the owner in the form of dividends is not generally in line with the cash that will be paid to the owner. Microsoft is the classic example of a company that has more cash on hand than it knows what to do with, yet they have traditionally paid no dividends. That might have changed in the last few years since I don’t follow them as much anymore. The cash they generated is the basis for a lot of valuation as opposed to the cash you would actually get in your pocket.
Unfortunately, when you see something like: “Most Valuable Companies You Don’t Own” type of articles out there, they will have the above problems and they won’t bother to really tell you about them. In a perfect world, the stock price would take the above business valuation and translate that to Stock Prices.
Stock prices should in theory be some sort of consensus on a business’ valuation. I think the price is more like a compromised average it has very little to do with the actual value of a business for the following reasons:
- Dumb people with lots of money. The stock price is swayed by number of shares purchased at a certain price. That makes some sense if you’re dealing with buyers that have any sense. Unfortunately, the price a person is willing to pay for a share is not necessarily well founded, researched, or even thought through. The assumption is that only smart, rational people are buying, but we all know that’s not the truth.
- Over/Under Reaction to News. One of the benefits of a public stock exchange and stock prices is that it is supposed to reflect the immediate changes in value from news. The problem is, when news hits, there is often a major gap in the supply of information. A topical example is Applet’s latest Tablet device. This thing could be the next iPod/iPhone or it could turn into another dud. The point is, people are trying to price the news without any real good information.
Stock prices include all of the problems of a Business Valuation with the added volatility of dumb people getting to vote with their money and reacting to news without good information. While I don’t know how to really address these problems, the only thing I could say to you is if you’re choosing to enter the stock market or buy into a company keep the above in mind and tread lightly.