Why a stock price won’t always reflect the value of its business
What the market thinks a stock is worth right now is not the same as its intrinsic value. There are many factors and actions to consider that the market can ignore or inflate. In this episode of “The Morning Show” on Motley Fool Live, recorded on December 21, Motley Fool analysts Sanmeet Deo and John Rotonti explain how and why real company values can change from moment to moment – and what you need to do about it.
Deo Sanmeet: I think this is where people go wrong when they look at the stock prices and think that is the value of the company. This is what the market thinks the business value is. Is the market generally right? Maybe, but in the long run. But it tends to overshoot and exaggerate upward and downward movements. Instead of anchoring to the old prices of what you owned it for, what the stock was is the appraisal trick, not to anchor but to identify the value of the action at the time depending on what it is going to do in five, 10 years. Like that stock that you said was worth 70, maybe it was really worth 50 when you did your valuation, then it fell to 20. But then you do another valuation, you think, you know what ? I think the value is 70 again because they’ve increased their income, their margins are improving, they’ve widened their markets, there are more options, let’s say – whatever fundamental things are happening. spend with the company. Now I think it’s worth 70. Would I buy it if it’s worth 20? If I think it’s 70, probably, because there’s this valuation haircut or this spread that I think is based on my valuation, not based on the price per se, but based on 70 of … it could be a complicated DCF model. It could just be a multiple of earnings or cash flow that you just reasonably assumed. This is the price you might want to buy it at. Are you going to be wrong? May be. Are you going to be right? May be. That’s the beauty of investing. You don’t know, but you just need to grasp the risk and then refine your assessment process over time and keep on iterating and saying, what am I learning from that and getting closer and closer to be able to find real value for business.
John Rotonti: Absoutely. Just think of companies in transition of business model or companies that add a whole new line of income with higher margin. Example, you could have several people, thousands, millions of investors rated Amazon when it was an e-commerce business. They found some value. Then Amazon made a very small announcement that they were going to start selling cloud services. They created a whole new line of business with cloud TAM. The infrastructure cloud isn’t as big as global retail, but it’s massive on its own. Global retail, I think TAM is like 3 trillion, maybe more, and global cloud, I think TAM is like a trillion. But we are talking about billions. Amazon is making this tiny announcement that it’s going to create a new line of business with a huge TAM and potentially higher margins. By the way, doesn’t require any inventory of any kind or anything like that. You had value and then they make that announcement, you’re going to have a very different value years down the road. Values change, fools. Intrinsic values are not static. For large companies, they tend to grow over time. Stock prices will go up. Anchoring on a past stock price does not make sense. We all do it, but it just doesn’t make sense.
Deo: Even the big investors are doing it. I’m sure Warren Buffett does. He was able to control it over time and focus on the right thing. There are different ways of valuing. Intrinsic valuation via DCF, relative valuation via multiples of what the company does in relation to other companies in its industry. There is a private market value or whatever you think the equity buyer, the private strategic buyer could buy the business for. You can look at past acquisitions and maybe find three different values and then you might be surprised. You can offer almost the same value or you can offer a wide range. The other thing is that an evaluation is not a number. It’s not $ 70 and 25 cents. It could be 50 to 75. This is your target rage. So how sure are you that you are in the bottom, in the top, or in the middle? It is an art form. Certainly people who have been in this business for 30, 40 years and more and who are still demanding. One thing I also want to know is that we are in an unprecedented time of pandemic, pre-pandemic, post-pandemic, and then now – I don’t even know what to call it yet, but I hope the pandemic wanes for endemic or whatever we want to call it. But during that two-year period, many companies experienced extreme volatility. Stock prices too, but in companies like their income cut. Their cash flow has stopped. Their business has exploded for the better, has exploded better. Are they going to be to maintain this? Probably not, because we are living in unprecedented times of a totally different global environment. But will they lose all of these pandemic gains? Probably not either. There’s a change in the way you think about things like home fitness or video calling, or email signatures, all of those things. There’s been kind of a boom and a recession, and as uncomfortable as owning some of these stocks that have gone up and down. I have a lot of stocks in my portfolio that I have gone from top to bottom. [laughs] There are a lot of them right now. Do I think their businesses are going to go back to pre-pandemic state and give it all back? No. Will this be what it was in 2020, from a business perspective? No. But while it might be a midpoint and with that midpoint, I have to think to myself, do I feel comfortable in this steady state or this slower increase in growth? Do I still feel comfortable owning a business or do I want to buy more of the business? This is actually what makes our job fun and challenging. [laughs]