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Because a company’s stock price is in theory what the market expects is the sum of the total future discounted cash flows that unit of “equity” generates. [1]

Because a company’s stock price is in theory what the market expects is the sum of the total future discounted cash flows that unit of “equity” generates. [1] This means that fundamentally, stocks are forward looking several decades and beyond. The economy right now might be bad but if the expectation is that there is a slow and long recovery lasting 2 years, if a company is expected to be operational, profitable and growing in year 3-year 10, those profits are built into the share price. [1] https://en.m.wikipedia.org/wiki/Valuation_using_discounted_cash_flows https://en.m.wikipedia.org/wiki/Valuation_using_discounted_c...

dcolkitt 6y ago
Exactly. Here's a very intuitive way to think about it. Disney World's revenue has currently fallen by 100% this period. How much do you think the fair market value of Disney World should decline by? Clearly the answer is much less than 100%. Even if Disney World stays closed for two years, it's clearly a very valuable asset. As an asset it probably has a 50 year effective life, so 2 years of closing represents no more than a 4% loss in cash flow. Interest rates are essentially zero, so Disney World should be no more than 5-6% less valuable than it was before the pandemic. The biggest risk for corporate assets isn't the direct impact of the lockdown. It's whether the experience leads to any permanent changes in people's behavior. If there's a permanent cultural shift where people stop going on vacation or visiting crowded amusement parks, then Disney World might be worth much less. But this is significantly more speculative than estimating the direct impact of the lockdown.
- skybrian 6y ago
  I assume you're ignoring the discount rate entirely for simplicity? It doesn't seem like money ten years from now should be worth the same as money today. But I guess that implies that interest rates should go up eventually.
  - jldugger 6y ago
    No, I think the OP addresses that obliquely here: > Interest rates are essentially zero
    - denismi 6y ago
      Interest Rates for very secure debt is essentially zero, but future corporate profit expectations are uncertain, so there would be some non-zero risk premium applied in the rate used for determining their present value.
- vadym909 6y ago
  This makes a lot of sense but then shouldn't this apply to stocks like Netflix or Peloton. That once the people get back to work and gyms, these companies will struggle to grow as fast and in a way face permanent damage till the next pandemic?
  - mlthoughts2018 6y ago
    No, it doesn’t work the same way because investors will already take this into account when modeling the future cash streams available. They will say, “in year X we expected the business to obtain $FOO cash flow due to increased usage during a pandemic stay-home order. But this anomalous usage doesn’t mean the company “lost” any growth if it’s numbers aren’t as strong later, instead we expect it to have $BAR cash flow in normal times.” In other words, temporarily gaining more revenue in a way that does not jeopardize the regularly predicted revenue in other times will not create a “permanent” lack of growth, under any reasonable model of discounted net present value. The only way it could have an effect like that is if it put some type of limitation or burden that reduced capacity for business later. For example, consider a toilet paper company instead of Netflix. Everyone rushes to buy tons of toilet paper right now, which looks like amazing revenue growth, but investors will ask if everyone is going to have the same demand later. Eventually there will be an issue between the supply chain to make that much toilet paper and the stored up stockpiles of people who don’t need to buy more. Some companies could go bust during that event, others might have cash reserves or other lines of business, and the effect on stock price will be related to these.
- ThrustVectoring 6y ago
  >The biggest risk for corporate assets isn't the direct impact of the lockdown. It's whether the experience leads to any permanent changes in people's behavior. Note that this is a risk for specific corporate assets, but less so for corporate assets as a whole. The things people are shifting their spending to generate offsetting profits in other companies; if we're buying electronics instead of airfare, this is good for electronics manufacturers and distributors and bad for airlines. If we own both, then this shift matters a lot less.
JMTQp8lwXL 6y ago
Does this also mean that the market fundamentally thought, during the Global Financial Crisis, that the sum of the total future discounted cash flows permanently fell significantly? I'd like to see how this concept would explain 2008. If it can, it further strengthens the thesis.
- kube-system 6y ago
  Yes. In fact, 465 US banks had their actual future cash flows go to zero and were closed permanently. A great number of other companies also never recovered and filed bankruptcy and/or were sold off.
- alkibiades 6y ago
  yes because if a company goes bankrupt it’s future profit goes to zero
- clomond 6y ago
  I think it’s tough to say and tie it in directly. My understanding of 2008 is that the over valuations were tied in with residential Real Estate and the associated MBS’ (mortgage backed securities - the owners of the loans). Everything else was largely contagion and concern around the sanctity of the financial system. The subsequent crash and economic calamity was focused on home owners, and existed within the financial system more broadly, not just stocks/equities. Maybe a better example is the dot-com bubble - many investors thinking that “the Internet was going to take over” etc etc pets.com. So the thesis at the time was tremendous growth rates for questionable business models. Once it was evaluated as a “bubble” =~= overvalued =~= these set of companies will never make back there money -> a stock price correction occurred.
- 6gvONxR4sf7o 6y ago
  Partly, that's where the "discounted" part comes in. The further out a profit, the less it factors into today's price. The other part, and this took me forever to realize, is how much "expectation" matters, in the sense of information. If on Monday, I flip a fair coin to decide whether or not to dissolve my business, and then tell you what the coin landed on on Wednesday, then the amount you'll pay for a share in my company on Tuesday is going to be incredibly different from what you'll pay Thursday. Noting for the business changed between those days. Only your perception changed, but it's insanely important. That's a reason swings can happen so near-instantly. The company's finances don't change that quickly, but the information available to investors does change that quickly (like on an earnings call, or after the release of an investigative report). So in 2008, the near future was weighted heavily and not rosy ("intrinsic" values go down), while investors realized they'd been wrong about their expectations (market prices go down further).
fzeroracer 6y ago
Doesn't this argument mean that the stock market should in theory be recession proof? If stocks are looking forward several decades, then it should be factoring in the recovery from any recession we face. Which as we've seen during various recessions doesn't seem to hold true.
- peacefulhat 6y ago
  Once investors become truly forward-thinking, snp will hit $30 quintillion 8^)
- kube-system 6y ago
  No, because traders don’t price the market as a whole, they price individual stocks. Some stocks will never recover, and some of that recovery will be companies that don’t exist yet. While these things might offset to create a market recovery, there’s no way to price in the expected cash flow for a company that doesn’t exist.
  - matthewdgreen 6y ago
    Traders can certainly spread their bets across many companies representing a business sector, and routinely do so. This "a few firms might go bankrupt so this explains why entire sectors experience massive volatility that isn't justified by long-term revenue expectations" claim seems like someone trying to rationalize irrational human behavior.
    - javagram 6y ago
      Ok, but take the airline sector for example. Maybe one or more of the airlines will go bankrupt. Maybe they all somehow survive. The price of Delta, United, American etc. gets discounted because the risk of each individual stock being bankrupted is high. But they don’t go to 0, because there’s also a chance each of the airlines might somehow survive to next year and go back to profitability. If all the airlines go bankrupt, someone will step in and create new companies in the sector by buying up the bankrupt companies’ physical assets, but the existing shareholders will lose everything despite the sector itself being viable in the long term.
bamboozled 6y ago
Why did it dip in the first place then? Within the first few weeks of Covid19 the circuit breakers were dripped many times, if the market is so forward looking, what happened then?
- tempestn 6y ago
  People thought the virus would hit harder, and so the long-term impacts would be worse, than they do now.
- lotsofpulp 6y ago
  The demand curves and supply curves are constantly shifting.
- IAmGraydon 6y ago
  For a short time, the market envisioned the apocalypse. That’s what the media was selling, and enough market participants bought it to temporarily cause a sell-off. Also, consider that a very large percentage of market trading is algorithmic. In this sort of situation, they often amplify the panic by detecting human panic in the market and automatically selling.
  - bamboozled 6y ago
    I don’t get this argument though, I have shares and I don’t think the apocalypse would make me sell them, what good is all of that cash ? The only people who should worry would be those who have all their savings in their share market, and I doubt the majority of share holders have all their money invested. Not sure this checks out. I’d sell because I’d hope to buy once we rescued the bottom though.
- cheez 6y ago
  The first sell off was emotional, the rest was forced margin selling. It was beautiful.
- kube-system 6y ago
  There is a difference between being forward-looking and being able to predict the future. Nobody thought the American economy was going to shut down, until it became clear that was going to happen. That was when we hit the circuit breakers.
dcftoapv 6y ago
Adding in a little more nuance. Free cash flow to equity is discounted at the cost of equity. The cost of equity increases as future cash flows become riskier. However, costs of financial distress tend not to get baked into valuations unless they are obvious because they are not part of the normal valuation process. This is why it might be possible that the stock market would not decline as much in 2020 / 2021 as it did in 2008 / 2009. However, something seems fundamentally wrong with valuations at the moment, I cannot put my finger on it, and so I'm overweight fixed income until I'm more comfortable that things are going to turn around.
kgwgk 6y ago
Is the ten-year outlook better now than it was one year ago?
Rickvst 6y ago
The thing is, in the formula, you have to use the rate "r" to discount the future profits. If the "r" decreases, the monetary value of stocks in the present increase, even though the cashflow has not changed. So, even if coronavirus decreases short-term profits, the effect it has on the global economy can lower interest rates, causing the present value of stocks to increase.
AmericanChopper 6y ago
> if a company is expected to be operational, profitable and growing in year 3-year 10, those profits are built into the share price. Certain buyers may be basing their decisions on expected profits in 3-10 years, but this certainly isn’t the only reason that somebody may choose to buy a stock. Also, in that situation they wouldn’t be pricing in the profits that they expect to be made, they would be pricing in what they think the actual probability of that happening is (which would include some probability of those expectations not being met). If the future earning potential of a company is already fully priced in, then you’d have little reason to buy the stock, because it wouldn’t have any room to increase in value.
clairity 6y ago
no one who values companies professionally predicts cash flows more than ~5 years out, certainly not decades, because predictions about economies, governments, societies, and institutions are all salient to those future cash flows and those predictions become rapidly worthless as you look further in the future. what happens in practice is that you take the cash flows of year 5 and you annuitize it into the far future with the estimated growth rate, and call it a day.
- wallacoloo 6y ago
  > no one who values companies professionally predicts cash flows more than ~5 years out > what happens in practice is that you take the cash flows of year 5 and you annuitize it into the far future with the estimated growth rate, and call it a day. How is that not a prediction?
  - clairity 6y ago
    it's done out of tradition, not prediction.
polote 6y ago
Whatever the valuation, you will always find one way to value a company which match the current valuation ...

dcolkitt 6y ago

Exactly. Here's a very intuitive way to think about it. Disney World's revenue has currently fallen by 100% this period. How much do you think the fair market value of Disney World should decline by? Clearly the answer is much less than 100%. Even if Disney World stays closed for two years, it's clearly a very valuable asset. As an asset it probably has a 50 year effective life, so 2 years of closing represents no more than a 4% loss in cash flow. Interest rates are essentially zero, so Disney World should be no more than 5-6% less valuable than it was before the pandemic. The biggest risk for corporate assets isn't the direct impact of the lockdown. It's whether the experience leads to any permanent changes in people's behavior. If there's a permanent cultural shift where people stop going on vacation or visiting crowded amusement parks, then Disney World might be worth much less. But this is significantly more speculative than estimating the direct impact of the lockdown.

skybrian 6y ago
I assume you're ignoring the discount rate entirely for simplicity? It doesn't seem like money ten years from now should be worth the same as money today. But I guess that implies that interest rates should go up eventually.
- jldugger 6y ago
  No, I think the OP addresses that obliquely here: > Interest rates are essentially zero
  - denismi 6y ago
    Interest Rates for very secure debt is essentially zero, but future corporate profit expectations are uncertain, so there would be some non-zero risk premium applied in the rate used for determining their present value.
vadym909 6y ago
This makes a lot of sense but then shouldn't this apply to stocks like Netflix or Peloton. That once the people get back to work and gyms, these companies will struggle to grow as fast and in a way face permanent damage till the next pandemic?
- mlthoughts2018 6y ago
  No, it doesn’t work the same way because investors will already take this into account when modeling the future cash streams available. They will say, “in year X we expected the business to obtain $FOO cash flow due to increased usage during a pandemic stay-home order. But this anomalous usage doesn’t mean the company “lost” any growth if it’s numbers aren’t as strong later, instead we expect it to have $BAR cash flow in normal times.” In other words, temporarily gaining more revenue in a way that does not jeopardize the regularly predicted revenue in other times will not create a “permanent” lack of growth, under any reasonable model of discounted net present value. The only way it could have an effect like that is if it put some type of limitation or burden that reduced capacity for business later. For example, consider a toilet paper company instead of Netflix. Everyone rushes to buy tons of toilet paper right now, which looks like amazing revenue growth, but investors will ask if everyone is going to have the same demand later. Eventually there will be an issue between the supply chain to make that much toilet paper and the stored up stockpiles of people who don’t need to buy more. Some companies could go bust during that event, others might have cash reserves or other lines of business, and the effect on stock price will be related to these.
ThrustVectoring 6y ago
>The biggest risk for corporate assets isn't the direct impact of the lockdown. It's whether the experience leads to any permanent changes in people's behavior. Note that this is a risk for specific corporate assets, but less so for corporate assets as a whole. The things people are shifting their spending to generate offsetting profits in other companies; if we're buying electronics instead of airfare, this is good for electronics manufacturers and distributors and bad for airlines. If we own both, then this shift matters a lot less.

JMTQp8lwXL 6y ago

Does this also mean that the market fundamentally thought, during the Global Financial Crisis, that the sum of the total future discounted cash flows permanently fell significantly? I'd like to see how this concept would explain 2008. If it can, it further strengthens the thesis.

kube-system 6y ago
Yes. In fact, 465 US banks had their actual future cash flows go to zero and were closed permanently. A great number of other companies also never recovered and filed bankruptcy and/or were sold off.
alkibiades 6y ago
yes because if a company goes bankrupt it’s future profit goes to zero
clomond 6y ago
I think it’s tough to say and tie it in directly. My understanding of 2008 is that the over valuations were tied in with residential Real Estate and the associated MBS’ (mortgage backed securities - the owners of the loans). Everything else was largely contagion and concern around the sanctity of the financial system. The subsequent crash and economic calamity was focused on home owners, and existed within the financial system more broadly, not just stocks/equities. Maybe a better example is the dot-com bubble - many investors thinking that “the Internet was going to take over” etc etc pets.com. So the thesis at the time was tremendous growth rates for questionable business models. Once it was evaluated as a “bubble” =~= overvalued =~= these set of companies will never make back there money -> a stock price correction occurred.
6gvONxR4sf7o 6y ago
Partly, that's where the "discounted" part comes in. The further out a profit, the less it factors into today's price. The other part, and this took me forever to realize, is how much "expectation" matters, in the sense of information. If on Monday, I flip a fair coin to decide whether or not to dissolve my business, and then tell you what the coin landed on on Wednesday, then the amount you'll pay for a share in my company on Tuesday is going to be incredibly different from what you'll pay Thursday. Noting for the business changed between those days. Only your perception changed, but it's insanely important. That's a reason swings can happen so near-instantly. The company's finances don't change that quickly, but the information available to investors does change that quickly (like on an earnings call, or after the release of an investigative report). So in 2008, the near future was weighted heavily and not rosy ("intrinsic" values go down), while investors realized they'd been wrong about their expectations (market prices go down further).

fzeroracer 6y ago

Doesn't this argument mean that the stock market should in theory be recession proof? If stocks are looking forward several decades, then it should be factoring in the recovery from any recession we face. Which as we've seen during various recessions doesn't seem to hold true.

peacefulhat 6y ago
Once investors become truly forward-thinking, snp will hit $30 quintillion 8^)
kube-system 6y ago
No, because traders don’t price the market as a whole, they price individual stocks. Some stocks will never recover, and some of that recovery will be companies that don’t exist yet. While these things might offset to create a market recovery, there’s no way to price in the expected cash flow for a company that doesn’t exist.
- matthewdgreen 6y ago
  Traders can certainly spread their bets across many companies representing a business sector, and routinely do so. This "a few firms might go bankrupt so this explains why entire sectors experience massive volatility that isn't justified by long-term revenue expectations" claim seems like someone trying to rationalize irrational human behavior.
  - javagram 6y ago
    Ok, but take the airline sector for example. Maybe one or more of the airlines will go bankrupt. Maybe they all somehow survive. The price of Delta, United, American etc. gets discounted because the risk of each individual stock being bankrupted is high. But they don’t go to 0, because there’s also a chance each of the airlines might somehow survive to next year and go back to profitability. If all the airlines go bankrupt, someone will step in and create new companies in the sector by buying up the bankrupt companies’ physical assets, but the existing shareholders will lose everything despite the sector itself being viable in the long term.

bamboozled 6y ago

Why did it dip in the first place then? Within the first few weeks of Covid19 the circuit breakers were dripped many times, if the market is so forward looking, what happened then?

tempestn 6y ago
People thought the virus would hit harder, and so the long-term impacts would be worse, than they do now.
lotsofpulp 6y ago
The demand curves and supply curves are constantly shifting.
IAmGraydon 6y ago
For a short time, the market envisioned the apocalypse. That’s what the media was selling, and enough market participants bought it to temporarily cause a sell-off. Also, consider that a very large percentage of market trading is algorithmic. In this sort of situation, they often amplify the panic by detecting human panic in the market and automatically selling.
- bamboozled 6y ago
  I don’t get this argument though, I have shares and I don’t think the apocalypse would make me sell them, what good is all of that cash ? The only people who should worry would be those who have all their savings in their share market, and I doubt the majority of share holders have all their money invested. Not sure this checks out. I’d sell because I’d hope to buy once we rescued the bottom though.
cheez 6y ago
The first sell off was emotional, the rest was forced margin selling. It was beautiful.
kube-system 6y ago
There is a difference between being forward-looking and being able to predict the future. Nobody thought the American economy was going to shut down, until it became clear that was going to happen. That was when we hit the circuit breakers.

dcftoapv 6y ago

Adding in a little more nuance. Free cash flow to equity is discounted at the cost of equity. The cost of equity increases as future cash flows become riskier. However, costs of financial distress tend not to get baked into valuations unless they are obvious because they are not part of the normal valuation process. This is why it might be possible that the stock market would not decline as much in 2020 / 2021 as it did in 2008 / 2009. However, something seems fundamentally wrong with valuations at the moment, I cannot put my finger on it, and so I'm overweight fixed income until I'm more comfortable that things are going to turn around.

kgwgk 6y ago

Is the ten-year outlook better now than it was one year ago?

Rickvst 6y ago

The thing is, in the formula, you have to use the rate "r" to discount the future profits. If the "r" decreases, the monetary value of stocks in the present increase, even though the cashflow has not changed. So, even if coronavirus decreases short-term profits, the effect it has on the global economy can lower interest rates, causing the present value of stocks to increase.

AmericanChopper 6y ago

> if a company is expected to be operational, profitable and growing in year 3-year 10, those profits are built into the share price. Certain buyers may be basing their decisions on expected profits in 3-10 years, but this certainly isn’t the only reason that somebody may choose to buy a stock. Also, in that situation they wouldn’t be pricing in the profits that they expect to be made, they would be pricing in what they think the actual probability of that happening is (which would include some probability of those expectations not being met). If the future earning potential of a company is already fully priced in, then you’d have little reason to buy the stock, because it wouldn’t have any room to increase in value.

clairity 6y ago

no one who values companies professionally predicts cash flows more than ~5 years out, certainly not decades, because predictions about economies, governments, societies, and institutions are all salient to those future cash flows and those predictions become rapidly worthless as you look further in the future. what happens in practice is that you take the cash flows of year 5 and you annuitize it into the far future with the estimated growth rate, and call it a day.

wallacoloo 6y ago
> no one who values companies professionally predicts cash flows more than ~5 years out > what happens in practice is that you take the cash flows of year 5 and you annuitize it into the far future with the estimated growth rate, and call it a day. How is that not a prediction?
- clairity 6y ago
  it's done out of tradition, not prediction.

polote 6y ago

Whatever the valuation, you will always find one way to value a company which match the current valuation ...