As the most speculative bull market in a few years churns higher, I am reminded once again why these things overshoot and then blow up. Whereas, when the market is down investors become extremely cautious and selective, when it resembles a slot machine that pays out every time, as it does right now, people quit worrying so much about niceties like profits or business models or the like.
In a monthly letter, my friend Zeke Ashton said something that tells me without a doubt that the lack of consideration doesn't stop at the individual investor. Discussing convertible bonds, he says that he could not find a single one out of 600 that warranted further investigation, adding that he cannot understand why investors would "accept such heavy probabilities of capital loss in return for only moderate potential profit."
Some, it seems, never knew what made stocks go up in the first place. So they guess. Generally, they guess badly.
Fortunately, the answer is extremely simple: Companies are valued based on the present value of all of their future cash flows. And note the word "cash flows," not earnings. A company that shows a profit of $0.17 per share on the income statement that has to invest $0.17 for equipment, property, and to offset options dilution isn't worth jack. Wanna know why we harp on "free cash flow?" Because that's where the truth lies.
But in these boom times, when stocks bought today are nearly assuredly going to be higher tomorrow, people have a different set of ideas of what makes investing success. Below are some examples, culled from emails I've received. Some, I would note, are taken somewhat out of context, where the full note was more sophisticated than this particular fragment.
1. Relative valuation. "Compared toXM Satellite Radio
2. Journalist opinion. "Forbes has obviously been paid by the shorts to bash Ivanhoe Energy
3. Analyst opinion. "Did you see the $50 target put on Overstock.com
4. Stock splits. "I think your [sic] wrong to bash stock splits. Look what Taser
5. Press releases. This one's my favorite -- I've got too many to quote, but they are most prevalent among companies that lack appreciable revenues, like Research Frontiers
6. The stock's gone up. It's like chants of "scoreboard" at a basketball game. "What you think of Elan
7. The shorts. "Shorts are destroying GeneMax (OTC BB: GMXX)!" Short sellers are blamed for company stock prices being lower through any number of schemes. Short sellers are also, though, blamed for company struggles. I doubt that the shorts have anything to do with the fact that this former dot-com -- now biotechnology company had zero revenues in its most recent quarter, down from $125. The impact of short sellers on a company's free cash flow: zero.
Looking for undervalued companies in a sea of overvalued and hyped ones? Take a gander at The Motley Fool's Hidden Gems newsletter for Tom Gardner's latest picks. Sign up for a free, 30-day trial here.
Bill Mann owns none of the companies mentioned here. If he did, the impact on their free cash flows would be, well, zero. Please see his profile for a list of his holdings.