Dear fellow investors / readers,
Today,
I would like to share with all a posting by Bernie Klinder, a Chief
Investment Officer on the said topic. All credit to the author. I am
sharing as I like the analysis and the author's view is in line with
Tradeview philosophy.
Once
again, these writings are just my humble sharing (not recommendation),
feel free to have some intellectual discourse on this. You can reach me
at :
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Bernie Klinder, MBA, Entrepreneur, and active investor for +15 years
Updated Aug 16, 2016 · Upvoted by Franklin Parker, Chief Investment Officer for an ultra high net worth family & investment group
When you buy shares
in a firm, you own a percentage of that company. Or in accounting terms:
(assets - liabilities = shareholder equity). The stock price however is
based (theoretically) on the previous number, plus the discounted cash flow of future earnings.
I'll spare you the math on discounted cash flows and
other value calculations, but most institutional professionals invest
based on a common set of formulas that determine where the stock price should be in
the future given some basic assumptions of growth, future earnings,
economic outlook, etc. So if a company is worth $100 million today and
they are expected to increase sales and profit margin, the value of the
firm will increase, as well as it's share price. (Typically that outlook
is 3–5 years, it's hard to predict longer term). So if the future value
is estimated to be near $120 million, then the stock price would rise
about 20%.
That is, if all investors were rational.
Most retail investors are not rational, and tend to overvalue a firm. A
recent example would be Nintendo, and the rush of inexperienced
investors “betting” that the Pokemon Go craze would make the company a
fortune. Astute investors read the fine print and knew that Nintendo was
only going to see about 30% of the profits. So the stock quickly became
overbought by retail investors, and shorted by the pros. The typical
cycle looks like this:
Like any market, if there are more buyers than sellers, the price goes up (regardless if the real value of
the firm has changed or not.) If the current stock price is $50 and no
one is willing to sell their shares for $50, then they may bid higher.
Conversely, if someone wants to sell their shares and no one is buying,
they will have to either lower their price or hold the shares until
prices recover. Any time there are more sellers than buyers, the price
will fall.
Professional investors make their money by calculating the real value of
a stock (this is not an exact science) and buying it below that value,
and selling it when it hits a threshold above that value. In the short
term, stock prices are based on often irrational expectations. Sooner or
later, they return to their actual value.
Another example is Tesla -
its market cap (share price x number of shares) is over $30 billion.
(In comparison, Ford and GM are each worth about $50 billion) Today's
stock price is around $230 per share, but Tesla’s actual book value is around $7.25 a share, or about $1 billion. The difference between those two numbers is the expectation of future earnings (that
Tesla will be the next big thing). However, the + $200 a share
difference (multiplied by 148 million shares) means that they need to
sell a lot of cars. The professionals think that the stock is way overvalued, and as a result over half the shares of Tesla are currently being sold short (betting the price will fall dramatically.)
Dividends are typical paid by large, stable, mature companies that
generate lots of cash. Growing companies reinvest their cash into the
business in order to keep growing. Instead of offering a dividend with a
yield of 2–4%, your “earnings” will be based on the gains in share
price as the firm increases in value. It's easier for 1 billion dollar
company to become a 2 billion dollar company, than for a 100 billion
dollar company to double in size. So the behemoths reinvest a smaller
overall percentage back into the business, and distribute the rest to
shareholders.
Hope this was helpful.
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