There is a theory in finance which says “The value of any asset is the sum of the present value of its future cash flows.”
Let’s take Warren Buffet’s famous Gumball Machine to explain this. Let’s say you own a gumball machine. The gumball machine gives you, after all the expenses spent on it, $100 every year as net revenue. You are about to sell this gumball machine now.
How much would you sell it for? The sum of the price of its spare parts? Seems reasonable. But let’s assume that the spare parts of the machine are long outdated and have no value in the market. So, should you give it away for free? No, of course not. The gumball machine is not just about its spare parts. It gives you the additional $100 in spite of the value of its spare parts. Shouldn’t you consider that? You should. If you held on to that gumball machine for eternity (Just consider), it would give you $100 perpetually.
However, getting $100 today is not the same as getting $100 5 years later. Time erodes the Value of Money. Let’s say that the interest rate in the country is 2%. This means that, to get $100 5 years down the line, you simply need to invest $90.60 today (Approximately) i.e. 90.60*1.02^5. This basically means that the present value of receiving $100 5 years down the line is equivalent to receiving $90.60 today.
Going back to our gumball machine with the understanding of the time value of money, we can easily determine, using the perpetuity formula, that the value of the gumball machine today is $100/0.02, which is $5000. This is the intrinsic value of the gumball machine. You should probably sell the gumball machine for $5000, give or take.
Now imagine an economy full of gumball machines. Everyone’s buying and selling gumball machines and all these machines are perfectly identical. What would you do if you find a gumball machine selling at $4500? You would buy it, definitely. Because just by paying $4500, you are getting a present value of $5000. $500 profit, cool. And what if you find gumball machines selling at $6000 in the economy? You will sell your gumball machine and make a cool profit of $1000.
Easy, right? Wrong. What if you buy the gumball machine at $4500 and suddenly there’s a huge drop in demand of gumballs? And what if because of that, your yearly net revenue drops to $60 instead? You would then be sitting on a present value of $3000, making a loss of $1500. You can make every beautiful assumption and pull out well-constructed forecasts, but in truth nobody knows the future. You only expect that your average yearly revenue will be $100. It can just as easily be $150 or it can be $60.
The gumball machine can be directly related to companies. In the case of companies, the $100 can be equated to the company’s free-cash flow (Cash flow of the company after accounting for all possible expenses and debt payments), although a company’s cash flow may vary from one year to another. You discount this free cash flow to its present value, divide it by the number of shares of the company and voila! You have the intrinsic value of the company. This is the premise of valuing a company’s share.
Let’s say you project, forecast and discount the free-cash flow on XYZ Company and arrive at the figure $25. This means that the price of XYZ company should tend to $25 in the share market. But you will find that this is not usually the case. The market is made up of millions of people and not everyone does a DCF Analysis of the stock before buying or selling it. They act on impulse and news, mostly. You might have figured out a really golden company, but if the majority of people in the stock market are not interested in the stock, it would barely move. Or quite simply, your projections and assumptions in the initial valuation phase might have been wrong.
“The markets can remain irrational longer than you can stay solvent.”
Also, a company’s share price is not all about numbers. It is also largely dependent on the company’s competitive position in the market, the company’s management and so many other fundamental factors, which need expertise to understand. Most people in the stock market may not care about this at all.
On top of all this, there is always the stark truth that the unpredictable can happen at any time. Take a look at the following graph of the historical price movement of a famous company’s share. Forget all the mathematical calculations and try to answer from instinct: “Will you buy this company’s share?”
If past performance was an indication of the future, you would be inclined to say “Yes”. I mean, heck, many Ivy-league educated Wall Street investors said “Yes”. That’s why the share price has increased sharply towards the end of the graph. But can you guess which company this is? It’s Enron.
Nobody knew Enron would get caught in the Accounting Scandal the way it did and nobody knew that it would wipe out the company. The most intelligent investors got out of Enron real fast, sure. But the the scandal caught everyone off-guard. Such events can happen to any company. At such times, it is only your expertise of in the business of the company that will help you determine if you should buy more of the stock or sell it. The shares of many big companies lost 50–60% of their value immediately after the 2008 crisis. If you’d invested in any of those companies, for instance GE or Goldman Sachs, for instance, you would be reaping profits now (You can look at their historical price movements in sites like Bloomberg).
So to answer the question, it is not difficult at all to determine the fair price (The price at which you are willing to buy) of a company’s share. It is, however, difficult to understand human beings. And human beings determine the market price (The price at which you can sell) of the company’s share. It takes years of expertise, patience and determination to make a huge profit out of the share market.
This article was written by Dinesh Sairam (PGDM, Batch 21, XIME-B)