Economies around the world are in a state of flux while equity markets have been extremely volatile. In this environment, what is the correct stock price of any company? How can we tell what the correct price is for stocks like Amazon, Microsoft, Nike or Walmart?

A seasoned investor would probably respond by stating that there is no such thing as a single correct answer. In a marketplace, each market participant, or investor, sets their own price for any stock and the prevailing price is the aggregate of all our views and the subsequent price set in the buying and selling of the shares. Generally, a marketplace is very good at gauging the fair price of something. There is an often-cited example of a group of people at a fair, trying to guess the weight of a cow. In this case, there is a true answer and guesses generally fall around that true answer, though some could be higher, others lower. Interestingly we often find that if we take the average of the entire group, the answer will be remarkably close to the actual weight of the cow. This same reasoning is used for financial markets. It becomes trickier, however, when valuing companies as the value of a company is based on future, unknown information rather than readily available data.

THE VALUE OF COMPANIES

Clients that I speak to often struggle with the concept of a share price being reflective of future information. I have had this conversation so many times that I actually have an example to make the concept more accessible. Consider a doctor that owns his own practice and is about to retire. They will typically attempt to sell that practice to a younger doctor that is looking to establish him or herself. What is that doctor actually buying? How much will the younger doctor pay the older doctor and what is it based on? The younger doctor is buying the stock of medication, general equipment and maybe even a building from the older doctor. However, the true value of the practice is in the established client base that the older doctor has built. The younger doctor is buying the practice in the hopes that those clients continue to come to the practice even after the older doctor has retired. Thus, the valuation of the practice will be based on future profit which will be realised when those long-standing patients continue to book appointments in the future. Similarly, if you buy stock in Apple, you are not simply buying the current inventory of iPhones, you are buying the right to the profits derived from the sale of future iPhones and other goods and services.

Inherently, the future is unknown so the market prices shares based on known information. However, this could provide an opportunity if you make an informed guess that the market doesn’t. Let’s assume we are considering an investment in an oil company that has told the market that its wells are close to drying up. The market will mark down the stock because the business itself may not be viable when the wells are dry. However, let’s assume that you took the view that the company would find a new well and survive. This is an example of unknown information and is an assumption that you are making. If your assumption proves right, and the company does find another well, then the market, upon finding this out from company management, will mark the stock up again, given its renewed viability. You would have benefitted because you would have bought the stock based on your assumption. Stated simply, if you take a view on something happening, that is outside what is known by the market, you could be rewarded for it, as the market only prices in known information. Excellent investors spend a lot of time considering the future to try and stay ahead of the market. This helps them to understand which companies could do well and why. However, future information is unknown and markets are full of surprises, so the best investors are never right 100% of the time. They simply aim to be more right than wrong.

If this were five or ten years ago, my initial three paragraphs would have fully stated how we can think about investing in companies. However, the last few years have seen a new trend in investing which is worth mentioning to complete the discussion. If we disregard future assumptions we can simply buy shares back and forth at higher and higher prices regardless of fundamentals. In early 2021 this was put to the ultimate test when users on the digital community network, Reddit, grouped together to bid up the price of stocks like AMC Group and GameStop.

The interesting thing about the move is that it had nothing to do with the future value of either company. In fact, arguably, both companies’ future prospects seemed rather bleak, as the pandemic dramatically reduced foot traffic at movie theatres, which hurt AMC, while games were being bought online rather than in physical stores, which hurt GameStop. Nevertheless, these traders bid the stock up and effectively colluded to keep the price higher. While there is nothing necessarily wrong with this strategy, it does require that investors continue to work together to keep the share price high. The problem is that to ultimately win, investors late into the movie stood to lose a lot while those early into the trade profited. In this sense, it mirrored a pyramid scheme. Thus, while the experiment was interesting to watch, it proved that future profits and prospects still determine the fair value of a company more than anything else.

STRATEGIES TO VALUE COMPANIES

Having studied finance and worked as both an analyst and portfolio manager I have learnt a number of tools to help me value companies. Unfortunately, most of those are unavailable to those outside my industry. Crucially, thanks to the 24-hour news cycle (which requires speed of information rather than depth), the data points quoted from my profession are often the most surface level and thus leave a lot to be desired. In many cases, no financial concepts are used to understand companies at all, and news agencies only quote stock prices. Consider the share price graph in figure 1. It represents the price of a single share in Tesla.

If the share price is the only indicator noted, then all we can really discuss is how much the share price is up versus down. In this case, from its peak, Tesla is down approximately 50%. Given such a significant drop in price does the stock present an opportunity? Without more information, it is impossible to say. The result is new terminology like “buy the dip” which simply encourages investors to buy a stock when it is down. For me, this is not ideal. Consider figure 2, which is the same price graph as in figure 1, but with my fair values overlaid onto the graph.

In figure 2 I have three values which represent different decisions. The green line (or margin of safety value) represents a relatively cheap price for Tesla that I would be happy to pay. The blue line (or fair value) is the realistic fair price, while the red line (or best-case value) is typically a selling level for most stocks. Ideally, I would like to buy a stock at the green line and sell at the red line. With my fair values superimposed onto the graph, it frames the conversation from Figure 1 very differently. Now the 50% drop in share price clearly does not make the share attractive or even fairly-valued – the stock is still relatively expensive. My levels are inherently personal, and I might have readers questioning the levels and how I got to those numbers. My calculations have Tesla’s revenue growing by close to 25% per annum while profit margins effectively double relative to current levels. Thus, within 10 years, this would make Tesla one of the largest automotive manufacturers in the world, while also being one of the most profitable, with profit margins similar to Ferrari who make far fewer cars and charge luxury-car margins. Despite my assumptions being quite bullish on Tesla, they still do not justify the current price of the stock.

Crucially, notice how the discussion changes in the latter part of the paragraph. Instead of talking merely about the movement in the share price, I start to talk about actual business fundamentals like revenue and margins. If we draw a line from our initial discussion of a doctor’s practice, it is like the younger doctor trying to understand the patient profile, whether they expect the business to grow, and how profitable they think it will be if they take it over. This is the type of conversation that I find fruitful when it comes to discussing companies and whether we should invest in them.

So how do you use this type of rationale when thinking about stocks without completing a degree in finance? The process that I use to value companies is called a discounted cash flow process and involves discounting cash flows back over a discrete period while setting a terminal, steady state for the company.

DISCOUNTED CASH FLOW ANALYSIS

If the above sentence seems confusing then I find my years of studying validated! However, like most things in finance, we can distil a complicated formula into a couple of terms which I present in equation 1.

The price of a share is positively related to the numerator on the right side of the equation and inversely related to the two terms in the denominator. Importantly, this is only an approximate value, hence my altered equals sign. Understanding these factors will give you a very good sense of what will happen with the price of a share. Here’s how you can think about the three factors on the right of this equation:

FUTURE EARNINGS

Future earnings are effectively the future profits of the business. Like the doctor example, it is those future profits that truly determine the value of a business today. The more profitable a business is expected to be, the higher the reasonable price of the share. We could expand future earnings into various other questions to add more detail to our analysis as I did above with Tesla. However, when it comes to understanding a collection of companies it will suffice to understand the economic growth in the region in which these companies operate – more on this later.

THE RISK-FREE RATE

This can be described in a variety of ways, but it is typically referred to as the rate of interest set by the central bank in any region. This rate often influences the rate you could receive from a bank deposit, like a fixed deposit, so if it goes higher you can expect a higher return at the bank. Conversely, it will make it more expensive to borrow money. The rate impacts companies in two ways: 1) companies will also borrow at a higher rate which will impact their ability to invest in their operations and grow and 2) investors are more likely to move money away from risky investments in companies in favour of investments in bank deposits as the rate of return goes higher. This is definitely the case in regions like the United States (US), Europe and Japan where interest rates have been zero or negative for many years, until recently. Investors often compare the rates of return between different investments and when one becomes more attractive we typically see a shift from one to the other. Thus, due to reasons 1 and 2, higher rates of interest result in lower expected prices for shares and equity markets.

THE EQUITY RISK PREMIUM

This is probably the most difficult term to explain and understand but, in short, it represents the rate of return that investors expect over what they would get at a bank or from the risk-free rate. It validates the risk they assume when investing in a company. The market sets this rate of return as part of its market pricing. The equity risk premium reflects the expectation of equity market participants of future events. Thus, if the market expects interest rates to increase in future, but those increases have not happened yet, we could see share prices fall, in anticipation of higher rates. If we refer to equation 1 above, the risk-free rate factor has not yet changed but stock prices will move lower because the equity risk premium will move higher to reflect the risk of interest rates moving higher. Thus, the equity risk premium is moving higher in anticipation of higher rates. When we eventually get the higher interest rates, which will be reflected by a higher risk-rate, the equity risk premium will settle back down again. Currently, we have a unique equity risk premium environment which I will discuss below.

THE MARKET IS A COLLECTION OF COMPANIES

The equation above should help you understand the moves in the equity market. If you see the market go up it’s either because: future earnings are going higher, interest rates are falling, or the equity risk premium is falling. Calculating the equity risk premium can be tricky but we should be able to have a view on the first two factors. Crucially, when we consider a market, we are thinking of a collection of companies rather than a single entity. While this makes discussing future earnings tricky, it also becomes easier. This is because future earnings of a collection of companies is usually related to the economic growth of that region. This should make sense as companies contribute to economic growth. So, if economic growth is falling, we can assume that company earnings will come under pressure. The risk-free rate is already a macroeconomic variable so we can treat it exactly the same for one company as we do for many.

CURRENT MARKET DYNAMICS

With this framework, we can now have a fruitful conversation about current market dynamics. There has been a dramatic sell-off of equities in the first half of the year. Why is that the case? It’s largely attributable to the risk-free rate in a variety of countries increasing. This has happened as central banks try and curb the pressure of inflation, which they typically do by increasing interest rates.

As we now know, increasing interest rates hurts companies which results in equity prices falling. The extent of the sell-off reflects the effect of sticky inflation, or persistent inflation, which has forced central banks, especially the US Federal Reserve, to be aggressive with their interest rate hikes. Thus far, future earnings expectations have stayed reasonably unaffected but they could come under pressure should higher rates start to hurt the economy. The war in the Ukraine is also causing a lot of uncertainty from an earnings perspective, as it is driving inflation up and that is cutting into consumers’ disposable income.

Crucially, the equity risk premium is also starting to increase, which is the market’s way of telling us something about the future. In this case, it is an indication that the market believes that there could be pressure on earnings that it is pricing in now. It could also be the market telling us that interest rates could go even higher which is also a risk to equity prices. We will have to wait for the next earnings season (which is starting as we speak), and get more feedback from central banks on inflation. We will then be able to more accurately gather if the market is right with its sell-off in equities and increase in equity risk premiums.

If we were to discuss the equity market before going through some of the theory in equation 1 the discussion would be rather bland and high level. By going one step further and highlighting the key factors that affect companies’ value and the market’s pricing, we can now delve deeper into how inflation, interest rates, economic growth and profits all relate to our expectations for the equity market. I encourage you to use this framework to analyse the information that you hear in the news or read in the newspaper. It should help to create a basis for constructing your own equity market view.