It is no secret that market perceptions play a significant role in valuing firms. It is, in fact, the discounting of future stories related to a business by the market that reflects its current valuation. I mean, market valuation, not intrinsic valuation.
These future stories are told as perceived, not as they actually unfold. That is why it is dangerous to accept market's views in the short term. Invariably, the stories are going to turn different. You cannot tell the story in zest; this is not the place to display excitement or dejection; investment decisions are done with real cash. Therefore, one of the key requirements of a successful investment operation is control over emotions. Put another way, the story has to be told not as likely to be perceived, rather, as more likely to develop. The probability of the story to become a reality should be rather high for an investment to bear fruit.
As noted, market valuations do not reflect those odds; this is true in the short term. However, in the long term, as the story actually emerges, the market adjusts the valuation accordingly. It is better to play the long term game for satisfactory returns. As much as the long term is uncertain, the investment returns are more predictable at least for certain businesses.
It is true that intrinsic value of a firm is the present value of its cash flows discounted at an appropriate rate. Accordingly, the value is affected by cash flows, their growth period and growth rate. Once we have estimates of these numbers, the value becomes a function of the expected rate of return.
The following is a snapshot of 3 big boys in the world of business. We have the latest annual revenues, 5-year average operating margins and 5-year average free cash flows to firm for each of the firms. None of the numbers are based on the trailing months.
Based on the above information only, how do we value each firm? All of them have been around for a fairly long period. The business model of each relies heavily on technology for its success. Each of them has disrupted its market in a significant way. They are all being managed by competent people. One is in the retail business, the other is into computer peripherals (and more) and the last one is in the advertising business.
As much as we would like to estimate the value of these firms, market as already done the work and given us its offer. Now it is up to us whether to buy them at those prices or leave for another day when the market is in another mood.
While its cash is building up at a very rapid pace, we would like to know the reinvestment plans of Apple; how long its story is going to continue like it did in the past and what it is going to do with its cash are what determine its value.
While Google's story appears to be more stable and credible, advertising market is not unlimited. It has boundaries and Google will have to operate within that.
It is Amazon that amazes me the most. How long it is going to be until it really starts generating cash flows? The market has been very patient and is playing a very long term game.
If we accept that it is the buy price that determines our investment returns significantly, we should be careful about what we pay; and this applies to Amazon, Apple and Google.
No comments:
Post a Comment