True worth of a business is always in a state of change due to diverse market factors.
In one of the many quotable quotes in the movie Night Train to Lisbon, I was intrigued by this one: “Fields are greener in their description, than in their actual greenness.”
Decoding the meaning led me to appreciate the reality of this statement even more. The underlying lesson is simply that often what you see is not what you get. That the company pretending to be rich may actually be poor.
The press release may actually be spin. And the stock touching new highs may be riding on artificial demand.
For this reason, in today’s article, we look at the concept of price to determine whether what we see is the “truth” or just empty “hype”.
Is it value or only what the greater fool is ready to pay? Is it noise or fact? Or is it all the above?
To help us understand, let’s use these two scenarios. First, take the ‘08 market. With all the 2,000-point decline, stocks weren’t worth any less after the decline than before.
So it was the difference in the perception and the willingness of the next person to pay for it. There was no change in the underlying businesses. Companies still pulled in the same cash flow, they still had the same book value and same assets.
Likewise, the 1,300-point drop in 2011 represented very little in terms of true pricing. What we learn from these two bearish episodes is that investors aren’t as rational as finance theorists often assume.
They have biases too, such as, herding tendencies, panic and irrational exuberance which lead to mispricing.
For that, prices are guaranteed to remain outside their “true” value range even for extended periods of time.
The second scenario is research work by Fischer Black – the renowned mathematician of the Black-Scholes Options Pricing Model fame.
His findings suggested that prices are indeed rational – albeit loosely – and bordered closely to the efficient markets hypothesis (the idea that prices in financial markets reflect all available information).
He further suggested that prices tended to stay between double (2x) and half (0.5x) of true value of the business. Subsequent studies have also arrived at the same conclusion.
So, back to our question above. Do prices tell the truth or not? Do prices capture the state of the business? This is my earnest conviction. They do not.
“True” values are hard to find. This is because at any given time, this ultimate figure is always in a state of flux as factors (both known and unknown, external and internal) affecting business keep playing out in real time.
The best we can do is work with “frozen” assumptions. This is why discount cash flows models (despite looking scientific) are highly subjective experiments, which result in a range of estimated figures.
The only truth is one market prices are part hype, part fact, part noise, part value and part everything else.
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Note: The results are not exact but very close to the actual.
