by Eddy Elfenbein, Crossing Wall Street
One of the foundations of investment analysis is the dichotomy between a stockās price and its value; the idea that a stockās price hops above and below its rightful value. But Iāll let you in on a little secret: thereās no such thing as value. Thereās no magic value gnome hiding underneath each stock. Instead, thereās only price.
Value is a fiction, but a highly useful one. Itās an excellent way for us to think about a stock.
Telling us that a stock is below its value doesnāt tell us much. What if the stockās value falls? Or what if the price/value gap grows wider? The price/value dichotomy is further complicated by the fact that price itself can impact value. For example, an elevated share price can make it easier for a company to raise money.
With any investment analysis, your constants are most likely highly contextual, and as a result, theyāll do a poor job of predicting out-of-sample results. That doesnāt bother me so much, and itās also why I donāt much care for price targets. For all their sophistication, valuation models arenāt reality. Theyāre merely a blurry and highly conditional image of reality.
The proper job of an analyst is to judge possible outcomes and their impact. Value is a tool, but it must always be seen within the context of if/then scenarios. Too often, modelers become enthralled by their model and donāt look at what the underlying message is. I always cringe whenever I see some perma-bear claim the S&P 500 is over-priced by a massive amount. The statement, by itself, is meaningless. I donāt know if heās right, but I know for certain that his model has a wide error range.
This is a subtle message to convey. Investments analysts should have a proper respect for reality, and a proper suspicion of make-believe.
Copyright Ā© Eddy Elfenbein
