The X by N story

As any stock trader knows, the Dutch East India Company was the first stock in human history to be traded.

In fact, the Amsterdam Stock Exchange, the first stock exchange in human history, was set up so that the shareholders of the Dutch East India Company could buy and sell their shares there.

There is a record of the Dutch East India Company in 1688.

At first the news came from the Cape of Good Hope that the Dutch East India Company had a good harvest in its colonies, and that the fleet was now returning to Holland with a full load of cargo;

It was not long before the people of the exchange and the great speculators suddenly reported that the whole fleet had run aground on the beach, and that all wealth had been lost.

Then the news that the fleet was out of danger and on its way again, that wealth had not been lost, and that stock prices had recovered;

As it turned out, the fleet sailed along normally and eventually returned to Amsterdam unharmed, amid a wave of optimism.

But stock buyers were soon disappointed again. After inspecting the cargo, it was found that it would fetch only 34 barrels of gold, whereas the original estimate was that it would fetch more than 50 barrels.

As the stock market fell, people did their best to spread the word that war with King Louis XIV of France was imminent, and that Holland would soon be occupied, with disastrous consequences such as higher taxes and a collapse of the market.

Within days, the stock price of the East India Company plummeted;

“By the end, people were literally begging for handouts with the stock, as if people were asking for a handout from the buyers. There was panic in the exchange, an unexplained convulsion, as if the world was going to end, the earth was going to fall, and the sky was going to collapse.”

Clearly, from the day they were created, stocks are inherently associated with speculation and risk.

New York University Stern School of Business has a professor, named Swath Damodaran, is an expert in stock valuation and corporate finance, he has proposed a set of stock valuation theory.

Damodaran argues that valuation in the capital market is not as objective and rational as traditional investors think. Instead, it often starts with a story that drives up the value of a company. When the company adds a numerical content to the story, it can persuade wary investors to buy stocks and take risks.

It doesn’t matter whether valuations are realized or not, as Soros says:

World economic history is a drama based on illusions and lies. The right way to get rich is to recognize the illusion, invest in it, and then get out of the game before the illusion becomes public knowledge.”

Clearly, a story about future possibilities, rather than reality, is the essence of stock price volatility.

Damodaran believes that stock valuation itself is a very subjective behavior, a thinks overvalued, B thinks undervalued, and then it is possible to deal with a certain price. The key to the valuation of a stock is not the level of its P/E ratio and dividend, but how you tell a set of money-making stories to this stock.

Once people know that there is a high probability that the story is true, they can turn that narrative into an assessment of the value of the company, primarily the market size of the industry in which the company operates, the cash flow of the company, and the operating risk. When that process is complete, it means that you have started to translate the story into a valuation number.

Then, it is necessary to make accurate valuation of the company with the help of various basic data, which is mainly the sum of the company’s earnings cash flow, and then consider the equity risk premium and even the risk of bankruptcy to complete the stock valuation.

When the stock is valued, everything is not all right, because the world is changing all the time, the stock valuation should also be dynamic, there needs to be a feedback loop, because the company itself and the environment changes, adjust your valuation, or even overturn the whole story.

In this way, the price of a stock is an X by N story.

X is how much money the investor thinks the company is going to make every year;

N is how long investors think the company will last.

To translate the story of X*N into a professional concept in the stock market, it is EPS (earnings per share) and PE (valuation multiple). Another level of understanding of N is how many years can the enterprise survive?

One aspect of stock valuation is X, but more important is N —

Unfortunately, in the short term, most people only care about X in the last year or two, but not about N.

The question is how do you personally make money in the process of telling stories?

The answer is:

Find the logical fallacies in this set of popular stories. The bigger the fallacies, the better the bet

Take the case of the S&P 500.

The story of the S&P 500 is simple: these 500 companies are always the world’s leading companies, and their earnings continue to grow, with overall earnings growth in line with or slightly above the annual growth rate of U.S. GDP, and a recession will only affect earnings in the short term.

Next, we continue to refine the story with the numbers needed for valuation.

First, the average valuation of the S&P 500 over the last 30 years is about 15-20 times earnings, which means we can estimate a reasonable level by calculating 15-20 years of free cash flow for the S&P 500.

Since the 2008 global financial crisis, US nominal GDP has grown at an annualized rate of about 3.7%, while the S&P 500 EPS has grown at an annualized rate of about 5.9%. We use US nominal GDP growth as low growth in our estimates, while the median of the two is 4.8% as high growth.

The S&P 500’s 2021 EPS is $198, and 2022 EPS is estimated to be about $225, using that as a baseline for the current S&P 500 valuation.

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Also consider the impact of a possible recession in 2023. In fact, the market is pricing in a future recession in order for the S&P 500 to fall below 4000.

By most estimates, the US economy will be in a recession in 2023 – based on the past 30 years or so, if the US economy is in a deep recession, EPS will fall by 60 per cent or more, but no matter how much, it will recover within three years at most and then rise higher.

For US stocks, the more profound effect of a recession is that stock market valuations will come down significantly as a recession approaches, assuming that the worst of the recession will reduce the S&P 500’s valuation from 20 times to 15 times.

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The story and the numbers are in. Add up the EPS for every year after 2022 to estimate a reasonable level for the S&P 500.

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Thus, according to Damodaran story valuation method, assuming a deep recession, the S&P 500 should go no lower than 3,640 and no higher than 5,890.

By contrast, the S&P 500 is at around 4100.

If you’re interested in a specific stock, you can certainly use this method. Damodaran valued Tesla, ZOOM, and Boeing, which nearly went bankrupt at the time, during the back-to-back circuit breakers in March 2020. See:

What should be a fair price for U.S. stocks in 2021?

 

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