This is one of a series of columns that were produced for Moneyweb Investor in which Stuart Theobald explores the intersection of philosophy of science and finance. This followed an earlier series for Business Day Investors Monthly on the same theme. This column was first published in April 2014.
In interacting with first time investors, I’m often astounded by what people think a share price represents. Some tell me a share trading at R10 must be twice as expensive as a share trading at R5. By that logic the cheapest share in the market is always going to be 1c. Others are sure the share price represents the quality of management or how well known the company is.
Lesson number one on share prices is always a very simple rule: share prices are never anything but the present value of discounted future cash flows. A share is nothing but the right to receive future cash flows, and the value of that share is nothing but the quantum of those cash flows, discounted for how certain we are about them.
Seeing things this way helps to eliminate a lot of behavioural biases we are prone to when thinking about shares. Buying decisions should have nothing to do with how familiar we are with the company brands (recognition heuristic), whether we already own or don’t own them (endowment effect), or whether we just happened to hear about them most recently (recall bias). It also means the recent performance of a share price is only indirectly about the future anticipated cash flows. It also helps eliminate another classic confusion: when a share price falls after paying out a dividend. It should fall by the amount of the dividend exactly, but simultaneously changing views of future cash flows can mean the actual share price change is slightly different.
Of course, putting things this way is deceptively simple. In fact it is very difficult to know what the future cash flows to a shareholder will be. It is also difficult to know how much to discount them by. If we know for sure that we will receive R100 in a year’s time, and our cost of capital is 10%, the present value is a simple calculation (100/1.10 = R90.90). But company cash flows are much harder to predict. So the discount rate has to reflect two things: the interest rate, including what it may be in future, and the probability that the expected cash flow will materialise. It requires knowing what revenue the company can generate, but also what the value of its assets are because they could also be a source of cash flow. The world is a complex place, and companies have many moving parts with differing levels of certainty about the future.
This difficulty in seeing the future, however, doesn’t mean we should content ourselves with bad forms of reasoning about shares instead. That is equivalent to embracing some new age cult because science hasn’t answered every question. Instead we should redouble our efforts to research companies and understand the risks to their cash flows and what their earning power is. Usually we do this from a portfolio perspective, so risk has to be considered in the context of what other holdings we have. When we hold a diverse portfolio, a law of large numbers starts to apply, which means that our predictions about cash flows tend to average out to the mean.
Ultimately we rely on financial information about companies, and other data about the markets and economies they operate in, in order to make these predictions. There are also fierce arguments about just which data is important. We tend to think that company profitability is what matters, yet major corporate frauds like Enron and, locally, Tigon, Alliance Mining and Blue Financial Services show how good profits can be reported while the company is actually in big trouble. Indeed, accounting standards and the discretion that management and auditors are able to exercise in some circumstances makes it difficult to know just how much we can rely on financial statements. Many analysts think the cash flow statement is a good way to escape these problems, but even this is subject to problems. For instance, most accounting standards require allow for the indirect method of composing cash flow statements, which means they take the income statement as a starting point and then add back non-cash items such as depreciation or tax provisions and changes in working capital. They are not directly generated by adding up the cash receipts and cash expenditures of the company. Two fund managers and academics from Highstreet Asset Management in Ontario recently came up with a new direct cash flow template that aims to eliminate the anomalies of indirect approaches, and have found that their template makes for a better predictor of share price performance than a standard cash flow template does.
Given these difficulties it is not surprising that some investors can be persuaded by purported short cuts to share price predictions, usually offered by software systems that come at a price. The old aphorism that a fool and his money are easily parted, comes to mind. To the extent that there are other factors involved in share price movements, the “animal spirits” that John Maynard Keynes once wrote about, there is just as much debate over whether the consequences are any more predictable. As I’ve written in this column before, trading systems based on the anticipated impact of human psychological biases don’t seem to outperform other strategies either. There is, unfortunately, no substitute for hard work in investing, except for one: just passively track the market and free ride on everyone else’s active decisions.