Talking Stocks(blogmaverick.com)
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Talking Stocks
http://www.blogmaverick.com/2008/09/08/talking-stocks-and-money/
27 comments
In order to exploit the "inefficient market hypothesis", you need to know what information is reflected in stock price and what is not. This means you need to know the market, not just the stock.
I'm not sure that's true. e.g. if you have a company that has real estate worth $10/share, and a business that's worth $10/share, and the stock trades at $15, you don't really need to know whether the market underestimates the real estate, underestimates the business, or some combination of the two.
I guess for certain kinds of dirty hedges (e.g. trading the crack spread and trading oil refinery stocks) you might need to know that.
I guess for certain kinds of dirty hedges (e.g. trading the crack spread and trading oil refinery stocks) you might need to know that.
You don't have complete information, so the market may know something about the stock that you don't. Even if you're right, the market can stay irrational longer than you can stay solvent. So you do need to know the market.
That's true. And I may know something about the stock that the market doesn't. It's pretty impractical to make your decisions by finding out that everyone else is wrong, rather than by ensuring that you're right (or as right as you can be). It doesn't scale, either -- AT&T used to have over a million shareholders, and interviewing every one of them about whether Ma Bell was going to raise their dividend next quarter sounds like a real chore.
Even if you're right, the market can stay irrational longer than you can stay solvent.
If you're leveraged, yes. If you aren't leveraged, you're going to be solvent forever. And anyway, arguing about the timing obscures the real decision -- I wouldn't discourage someone from pursuing a career because I didn't know whether or not every employer would recognize their talent after the first interview.
Even if you're right, the market can stay irrational longer than you can stay solvent.
If you're leveraged, yes. If you aren't leveraged, you're going to be solvent forever. And anyway, arguing about the timing obscures the real decision -- I wouldn't discourage someone from pursuing a career because I didn't know whether or not every employer would recognize their talent after the first interview.
The market is the inefficiency, not the stock. In order to exploit these iniffeciencies, you need to decouple the fundamentals of the underlying company with the fundamentals of the market. The price at which a financial instrument trades is simply the sum of the market supply and demand. That's the big secret. If supply runs out and demand is still there, the price will go up until someone is willing to supply more stock.
That's true, but it sounds like you're talking more about speculation (guessing prices irrespective of values) rather than investing (purchasing when the price does not reflect full value).
A Random Walk and Efficient Market Theory are misunderstood and misrepresented.
People equate efficient market with perfect market, meaning the market "knows" the right price. All that efficient market theory states is that information is communicated efficiently, not that the information is correct. Other bubbles would never happen.
Proponents state that prices are only correct in the long run. Malkiel (author of A Random Walk) advocates whole market index funds simply because you cannot know what information is correct and beating the market is a fool's errand. Again the case in point being the irrational run up in tech stocks not based on fundamentals but based on the greater fool theory. Information as pricing was communicated effectively but the information is not guaranteed to be either correct or rational.
The stock market is a weighing machine not a voting machine - Benjamin Graham.
However, I do enjoy Cuban's take on this as he's been there and down that. I think he could write a great book at some point.
People equate efficient market with perfect market, meaning the market "knows" the right price. All that efficient market theory states is that information is communicated efficiently, not that the information is correct. Other bubbles would never happen.
Proponents state that prices are only correct in the long run. Malkiel (author of A Random Walk) advocates whole market index funds simply because you cannot know what information is correct and beating the market is a fool's errand. Again the case in point being the irrational run up in tech stocks not based on fundamentals but based on the greater fool theory. Information as pricing was communicated effectively but the information is not guaranteed to be either correct or rational.
The stock market is a weighing machine not a voting machine - Benjamin Graham.
However, I do enjoy Cuban's take on this as he's been there and down that. I think he could write a great book at some point.
I agree with most of what he writes, other than his dividends vs share buybacks commentary. I'm glad he published the descending comments though. A few quick thoughts:
1. Dividends are taxed, share buybacks are not. This is why in cases where a mature Company is sitting on a large pile of cash with little to no long term debt, share buybacks provide more value by avoiding the tax man.
2. If the management team truly believes the company is undervalued, buying shares back makes a lot of sense, especially for mature companies. However, if the buy back leads to incentive bonuses for the management team I'm 100% against it. Also, it's a lot more telling when a Company does this during a recession than a boom.
3. As alluded to in the comments, corporate earnings are relatively worthless without a cash flow statement for the same time period.
1. Dividends are taxed, share buybacks are not. This is why in cases where a mature Company is sitting on a large pile of cash with little to no long term debt, share buybacks provide more value by avoiding the tax man.
2. If the management team truly believes the company is undervalued, buying shares back makes a lot of sense, especially for mature companies. However, if the buy back leads to incentive bonuses for the management team I'm 100% against it. Also, it's a lot more telling when a Company does this during a recession than a boom.
3. As alluded to in the comments, corporate earnings are relatively worthless without a cash flow statement for the same time period.
A stock buyback only increases the fundamental value of the company if it results in an increase in dividends per share. A company that buys back stock instead of paying dividends, and also has no intention of ever paying dividends, would only be valuable in the way a baseball card is valuable.
Right, which is why I said "mature company" (who is hopefully, by then, issueing dividends :-D). At the same time, if a company issues dividends it can't afford to pay (cough Citi cough) this can be devastating to a Company's prospects.
At it's core, the whole reason stocks are worth anything to begin with is the anticipation of future dividends (DCF).
At it's core, the whole reason stocks are worth anything to begin with is the anticipation of future dividends (DCF).
I've been reading about stock trading over the last couple months, as time allows, thanks to Metlife managing my 403b to a phenomenal 1% growth over 5 years. Hands down the best book I've read so far is, Fire Your Stock Analyst: Analyzing Stocks On Your Own (Definitive Guides (Financial Times/Prentice Hall).*
All other books I've seen are "get rich quick." FYSA is the only one that has told me what the terms mean, how to calculate the "fundamentals", and where/how to research a company. It also gives examples of value and growth strategies. It doesn't, ever, tell you what you need to do to get rich, but rather, what you need to do to make informed decisions.
Mix in "common sense" and your own opinions and your off!
* Yes, I've read (most of) a Kramer book, too. Avoid at all costs. The only useful advice: buy and research (not buy and hold), it is possible to make money in down markets too, and sometimes its better to be in cash instead of stocks while you find your next position. The other 350 pages is about how EASY it is too make MAAAAD MOOOONNEY. Don't you want MAAAAD MOOOONNNNETY??!?11
All other books I've seen are "get rich quick." FYSA is the only one that has told me what the terms mean, how to calculate the "fundamentals", and where/how to research a company. It also gives examples of value and growth strategies. It doesn't, ever, tell you what you need to do to get rich, but rather, what you need to do to make informed decisions.
Mix in "common sense" and your own opinions and your off!
* Yes, I've read (most of) a Kramer book, too. Avoid at all costs. The only useful advice: buy and research (not buy and hold), it is possible to make money in down markets too, and sometimes its better to be in cash instead of stocks while you find your next position. The other 350 pages is about how EASY it is too make MAAAAD MOOOONNEY. Don't you want MAAAAD MOOOONNNNETY??!?11
The points he makes at the end of his "My Investment advice for 2006" are dead-on, especially points 2 and 3. Investing well in the market requires a lot of time - saving money doesn't, and investing in yourself (side projects for example) probably has the greatest potential for wealth generation.
"What about fundamentals? Fundamentals is a word invented by sellers to find buyers."
I used to work in the finance & investing industry before doing a startup. The slimy, misleading marketing proliferating itself everywhere is absolutely ridiculous. They're even pretentious enough to call their fees and back loaded funds "products".
If you've ever seen the movie Boiler Room, my second finance job was similar. My third finance job had similarities to Barbarians at the Gate (on a much lower scale) and the classic tulip bulb story: http://en.wikipedia.org/wiki/Tulip_mania
Strange world is the finance.
If you've ever seen the movie Boiler Room, my second finance job was similar. My third finance job had similarities to Barbarians at the Gate (on a much lower scale) and the classic tulip bulb story: http://en.wikipedia.org/wiki/Tulip_mania
Strange world is the finance.
This is a very well reasoned argument although it is rather depressing. I'm actively evaluating a few stocks to invest my meager savings. Mark Cuban has made me think one thing... bonds.
I personally couldn't entrust my wealth to someone named "Raleigh Rails." But then I don't actually have any wealth.
The secret to building a sustainable growing investment portfolio: DCF
Explain
Discounted Cashflow Model is one of the most robust way to value a company (whether public or private). Unlike other models like the dividend model, price/earnings model, a DCF model is flexible enough to value almost all type of businesses (early stage, high-growth, maturing).
And its fundamental concept is so simple: You just need to make really good guesses of the future cashflows and discount it back to the present and what you get is the intrinsic value.
Assuming this public company is valued at $1 billion but based on your inside knowledge of the company's projected cashflows, you derive an intrinsic present value of $5 billion - it's a screaming buy.
Later, as time goes by and the company meets your previous cashflow projections, the market will adjust their valuation to your initial calculation and voila, you're in the money.
Other models like P/E and dividend don't work well. Earnings and dividends can be manipulated SO EASILY. Imagine some dying company borrowing lots of cash in order to increase their dividend. Based on the dividend model, its valuation increases.
So the only thing you can back your life on is the cashflow. You can't just manufacture cash.
DCF can help you explain several phenomenons. Eg. why doesn't Salesforce crash despite its high P/E? Because the bulk of Salesforce customers pay upfront. So there's a lot of cash coming in and that cash has value.
So here's a fun exercise for you to do today: Project Facebook's cashflow for the next 10 years and discount it back to the present and compare it with Microsoft's $15 billion valuation. Then you can tell people whether Microsoft overpayed.
Happy DCFing!
And its fundamental concept is so simple: You just need to make really good guesses of the future cashflows and discount it back to the present and what you get is the intrinsic value.
Assuming this public company is valued at $1 billion but based on your inside knowledge of the company's projected cashflows, you derive an intrinsic present value of $5 billion - it's a screaming buy.
Later, as time goes by and the company meets your previous cashflow projections, the market will adjust their valuation to your initial calculation and voila, you're in the money.
Other models like P/E and dividend don't work well. Earnings and dividends can be manipulated SO EASILY. Imagine some dying company borrowing lots of cash in order to increase their dividend. Based on the dividend model, its valuation increases.
So the only thing you can back your life on is the cashflow. You can't just manufacture cash.
DCF can help you explain several phenomenons. Eg. why doesn't Salesforce crash despite its high P/E? Because the bulk of Salesforce customers pay upfront. So there's a lot of cash coming in and that cash has value.
So here's a fun exercise for you to do today: Project Facebook's cashflow for the next 10 years and discount it back to the present and compare it with Microsoft's $15 billion valuation. Then you can tell people whether Microsoft overpayed.
Happy DCFing!
So the only thing you can back your life on is the cashflow. You can't just manufacture cash.
Yes, you can. Read up on Enron's repo agreements. They raised cash by selling assets near the end of the quarter, and promising to buy them back at the start of the quarter -- it was underhanded, but it still showed up as operating cash flow. They did this for t-bills, Nigerian barges, and everything in between. Cash flow quality is higher than earnings quality, but it is by no means perfect.
Yes, you can. Read up on Enron's repo agreements. They raised cash by selling assets near the end of the quarter, and promising to buy them back at the start of the quarter -- it was underhanded, but it still showed up as operating cash flow. They did this for t-bills, Nigerian barges, and everything in between. Cash flow quality is higher than earnings quality, but it is by no means perfect.
The DCF model adjusts to this situation perfectly.
They raised cash by selling assets near the end of the quarter, and promising to buy them back at the start of the quarter
So there is an initial cash inflow at the end of the quarter and a cash outflow at the start of the next quarter. Just add that in your DCF analysis.
When I say you can't just manufacture cash, I'm talking about free money with no strings attached. In your Enron example, there is a string attached - they have to buy it back in the future, so there is a projected cash outflow in the future. No company can manipulate the books to inject $100 million from the thin air. That $100 million has to come from somewhere - from debt, equity investment, asset sales etc.
Earnings is so unreliable. Eg. this company is projected to earn $1 million with annual growth of 10% from Year 1 to Year 10. But they have a major debt ($100 billion) that is due on Year 11. A DCF model would value this company correctly as bankrupt while an earnings model would not be able to value this company correctly.
They raised cash by selling assets near the end of the quarter, and promising to buy them back at the start of the quarter
So there is an initial cash inflow at the end of the quarter and a cash outflow at the start of the next quarter. Just add that in your DCF analysis.
When I say you can't just manufacture cash, I'm talking about free money with no strings attached. In your Enron example, there is a string attached - they have to buy it back in the future, so there is a projected cash outflow in the future. No company can manipulate the books to inject $100 million from the thin air. That $100 million has to come from somewhere - from debt, equity investment, asset sales etc.
Earnings is so unreliable. Eg. this company is projected to earn $1 million with annual growth of 10% from Year 1 to Year 10. But they have a major debt ($100 billion) that is due on Year 11. A DCF model would value this company correctly as bankrupt while an earnings model would not be able to value this company correctly.
So there is an initial cash inflow at the end of the quarter and a cash outflow at the start of the next quarter. Just add that in your DCF analysis.
But you don't see it! All they have to do -- all they did -- was repo a little more at the end of the next quarter. RJR did this with cigarettes a while back: they offered discounts and 100% refunds to customers who bought just before the end of the quarter, and they ended up with extra cash for their 10-Q even though these actions hurt the business.
A few other scenarios a cash flow analysis misleads you on:
* Gradual liquidation: if a company sells off its inventory and equipment over time, it can show positive, growing cash flow (and a rapidly growing cash flow as a proportion of capital!) even though the business is falling apart.
* A company with a few long-lived assets, like an airline with just a couple planes, will show low earnings and high cash flow when it's not replacing a plane. This is one of those situations in which high cash flow is deceptive and earnings are not.
this company is projected to earn $1 million with annual growth of 10% from Year 1 to Year 10. But they have a major debt ($100 billion) that is due on Year 11
If the debt is normal debt, that shows up on the balance sheet, and the interest payments. If it's a zero-coupon bond, it shows up in the income statement but not the cash flow statement (although the tax effect shows up in both).
The point of earnings is to show what kind of value has been added to the business over time. We might call this Platonic version Earnings. Cash flow is a better way to approximate Earnings when companies are manipulating their earnings, but not when they're manipulating both. In the long run, given a perfect accounting system, DCF will equal Tangible Book + Discounted Earnings. Since accounting is imperfect, and a business can be manipulated to appear better than it really is by any measure that people actually use to value companies, picking just one kind of valuation is folly. I use free cash flow, but I use it judiciously -- I try to make it as much like Earnings as possible.
But you don't see it! All they have to do -- all they did -- was repo a little more at the end of the next quarter. RJR did this with cigarettes a while back: they offered discounts and 100% refunds to customers who bought just before the end of the quarter, and they ended up with extra cash for their 10-Q even though these actions hurt the business.
A few other scenarios a cash flow analysis misleads you on:
* Gradual liquidation: if a company sells off its inventory and equipment over time, it can show positive, growing cash flow (and a rapidly growing cash flow as a proportion of capital!) even though the business is falling apart.
* A company with a few long-lived assets, like an airline with just a couple planes, will show low earnings and high cash flow when it's not replacing a plane. This is one of those situations in which high cash flow is deceptive and earnings are not.
this company is projected to earn $1 million with annual growth of 10% from Year 1 to Year 10. But they have a major debt ($100 billion) that is due on Year 11
If the debt is normal debt, that shows up on the balance sheet, and the interest payments. If it's a zero-coupon bond, it shows up in the income statement but not the cash flow statement (although the tax effect shows up in both).
The point of earnings is to show what kind of value has been added to the business over time. We might call this Platonic version Earnings. Cash flow is a better way to approximate Earnings when companies are manipulating their earnings, but not when they're manipulating both. In the long run, given a perfect accounting system, DCF will equal Tangible Book + Discounted Earnings. Since accounting is imperfect, and a business can be manipulated to appear better than it really is by any measure that people actually use to value companies, picking just one kind of valuation is folly. I use free cash flow, but I use it judiciously -- I try to make it as much like Earnings as possible.
they offered discounts and 100% refunds to customers who bought just before the end of the quarter, and they ended up with extra cash for their 10-Q even though these actions hurt the business.
DCF deals with this. They get upfront cash but since these actions hurt the business, it hurts cashflow in the future. So it's not like as if they got off scot-free with this strategy. Like I said, DCF requires that you have really good estimates about future cashflows. If you say But you don't see it!, then you are not making good estimates.
Note: My point is not that DCF will give you a 99.99% accurate valuation. No model will since all models depends on the accuracy of the inputs. My point is that given the amount of knowledge you have about a particular company, the DCF model provides the best framework to reaching a fair valuation.
A company with a few long-lived assets, like an airline with just a couple planes, will show low earnings and high cash flow when it's not replacing a plane. This is one of those situations in which high cash flow is deceptive and earnings are not.
It is not deceptive. If the company does that, you just assume their future cashflow from operations will decline from the aging planes.
While other valuation models are useful in supporting your initial valuation calculations, DCF is the fundamental block.
DCF deals with this. They get upfront cash but since these actions hurt the business, it hurts cashflow in the future. So it's not like as if they got off scot-free with this strategy. Like I said, DCF requires that you have really good estimates about future cashflows. If you say But you don't see it!, then you are not making good estimates.
Note: My point is not that DCF will give you a 99.99% accurate valuation. No model will since all models depends on the accuracy of the inputs. My point is that given the amount of knowledge you have about a particular company, the DCF model provides the best framework to reaching a fair valuation.
A company with a few long-lived assets, like an airline with just a couple planes, will show low earnings and high cash flow when it's not replacing a plane. This is one of those situations in which high cash flow is deceptive and earnings are not.
It is not deceptive. If the company does that, you just assume their future cashflow from operations will decline from the aging planes.
While other valuation models are useful in supporting your initial valuation calculations, DCF is the fundamental block.
In theory, but the whole point of this article is that future cash flow will be exactly $0 when there are no dividends paid. There is nothing concrete to which you can actually tie the current value.
Therefore, the price is what someone is willing to pay in hopes that when they but it now there will be someone willing to pay more in the future.
Therefore, the price is what someone is willing to pay in hopes that when they but it now there will be someone willing to pay more in the future.
Future cash flow will not be $0 if there are no dividends paid. If a company has revenue, it has cash coming in and out and hence it has cash flow.
In any case, a company will be worth more if it doesn't pay out dividends since there is no cash outflow from the company.
With a DCF model, you are evaluating the cash inflow and outflow from the company perspective, not the shareholder perspective.
There is nothing concrete to which you can actually tie the current value.
There is - the cashflows of the company.
Imagine a company with net cashflow of -10 million for the first 5 years and +10 billion thereafter. You just discount back the cashflow and you'll get the intrinsic value of the company.
In any case, a company will be worth more if it doesn't pay out dividends since there is no cash outflow from the company.
With a DCF model, you are evaluating the cash inflow and outflow from the company perspective, not the shareholder perspective.
There is nothing concrete to which you can actually tie the current value.
There is - the cashflows of the company.
Imagine a company with net cashflow of -10 million for the first 5 years and +10 billion thereafter. You just discount back the cashflow and you'll get the intrinsic value of the company.
He may be suggesting that you buy some Dohar Cattle Feed Company stock (that's what I get when I search Google Finance for 'DCF'), but it's probably a reference to discounted cash flow, a very useful tool for evaluating certain business.
The idea of DCF is to split up the value of an investment into chunks of future cash flow, and ask yourself how much you'd pay for each chunk. For a simple example, if you have a business that's sure to pay you $100, once, a year from now, you ask yourself: how much would I have to put in the bank, now, to get $100 on that date? That amount is the present value of that cash flow.
Now consider a business that will pay that same certain $100, but after two years. The principle is the same -- how much would you put into a bank account now to get that same $100 on the same date?
To further complicate things, imagine that you're betting on a coin flip: two years from now, you will get either $100 (heads) or $0 (tails). To figure out the net present value, you'd first determine the average outcome ($50), then decide how much you'd have to put in a risk-free account now to get that amount in two years.*
Put these together, and you can understand the DCF framework. Let's say you have a business that earned $100 last year, and that you expect to earn about 5% more each year thereafter. But in any given year, there's a 10% chance that the business will go under. The discounted future value is that same procedure, repeated for each year: the price you should pay is how much you'd invest in a bank account now for a 90% chance of $105 in a year, plus an 81% chance of $110.25 in two years, etc., or sum(100 * 1.05^n * .9^n * [1 - risk-free interest rate]^n).
So now all you have to do is 1) figure out what the business will earn every year from now until the end of time, and 2) figure out the intrinsic value of a given sum of money to be delivered at a given future date. These are both, of course, impossible. But rough estimates get you pretty close to where you need to be, and it provides a good way to compare two stable-growth businesses in the same industry (how much should you pay for a soft drink company growing at 3% each year, versus an otherwise identical company growing at 5% each year, for example?).
* This assumes you have an infinite tolerance for risk. But a one in a billion chance of one billion dollars is probably not worth a dollar -- or, rather, it's worth more than a dollar if you enjoy gambling, and less than a dollar if you intend to retire on it.
Edit: replaced a second '$105' with the correct number, $110.25.
The idea of DCF is to split up the value of an investment into chunks of future cash flow, and ask yourself how much you'd pay for each chunk. For a simple example, if you have a business that's sure to pay you $100, once, a year from now, you ask yourself: how much would I have to put in the bank, now, to get $100 on that date? That amount is the present value of that cash flow.
Now consider a business that will pay that same certain $100, but after two years. The principle is the same -- how much would you put into a bank account now to get that same $100 on the same date?
To further complicate things, imagine that you're betting on a coin flip: two years from now, you will get either $100 (heads) or $0 (tails). To figure out the net present value, you'd first determine the average outcome ($50), then decide how much you'd have to put in a risk-free account now to get that amount in two years.*
Put these together, and you can understand the DCF framework. Let's say you have a business that earned $100 last year, and that you expect to earn about 5% more each year thereafter. But in any given year, there's a 10% chance that the business will go under. The discounted future value is that same procedure, repeated for each year: the price you should pay is how much you'd invest in a bank account now for a 90% chance of $105 in a year, plus an 81% chance of $110.25 in two years, etc., or sum(100 * 1.05^n * .9^n * [1 - risk-free interest rate]^n).
So now all you have to do is 1) figure out what the business will earn every year from now until the end of time, and 2) figure out the intrinsic value of a given sum of money to be delivered at a given future date. These are both, of course, impossible. But rough estimates get you pretty close to where you need to be, and it provides a good way to compare two stable-growth businesses in the same industry (how much should you pay for a soft drink company growing at 3% each year, versus an otherwise identical company growing at 5% each year, for example?).
* This assumes you have an infinite tolerance for risk. But a one in a billion chance of one billion dollars is probably not worth a dollar -- or, rather, it's worth more than a dollar if you enjoy gambling, and less than a dollar if you intend to retire on it.
Edit: replaced a second '$105' with the correct number, $110.25.
Heh, that's exactly what I'm experiencing now. I've always bought the efficient markets hypothesis (i.e., that current prices already factor in all available information). But, I've been meeting analysts who are supposedly experts in their respective fields, and I've come to a simple conclusion: they can't interpret the information they're given.
They are the kind of people who consider valuation by a constant multiple of eyeballs to be legitimate. They are the pointy-haired-bosses of the world, who read a few trade rags and think they are experts.
In one light, it's all rather depressing. In another, it seems like a great opportunity ;-)