On Charlie Rose this week, Felix Salmon made a good point about market volatility:
It is impossible to know the value of a company like Apple or Goldman Sachs to within a half a percent either way. But that's what you wind up doing when you look at the stock price. You say, "Oh it went up a percent! Or down a percent!" That is pure noise in the distribution of roughly, more or less, where we think [the price] should be.
How true. And this is something that private companies handle better than public companies.
When a private company wants to know how much it is worth, management hires an investment bank, or a valuation consultant, which provides a "fairness opinion."
Analysts look at the company's financial statements, do some wizardry in Excel, and come up with a reasonable estimate for what the company is worth.
But when an investment bank presents a private business owner with a fairness opinion, you will almost never see this:
We think your company is worth $18.16 per share.
Instead, you'll almost always see something like this:
We think your company is worth between $17 and $19 per share.
Valuations are given in a range, not an exact value.
There's a good reason for this.
All valuation estimates are just that -- estimates. They're an attempt to predict a future that, in reality, cannot be known.
To value a company, I have to know what future interest rates will be, for example. But I don't. And I can't.
I can, however, come up with a reasonable range of possibilities.
I can't look at you with a straight face and say 10-year Treasuries will yield 4.21% in January 2017. But if I said there's a good chance 10-year Treasuries will yield somewhere between 3% and 5% in January 2017, that's more realistic. (The range could still be off, but it has a better chance of being more or less right.)
Same goes with earnings growth, capital spending, cost of goods sold, and dozens of other variables. The future is thought of in a range of probabilistic outcomes, so current valuations are presented in a range, too.
But the stock market doesn't.
As I write, I can see Apple is worth $116.45 a share. There's no range of possibilities -- not "between $100 and $125 a share." The exact value, right now, is $116.45. That's what the market estimates Apple's future cash flows are worth, discounted back to today.
But not even the market, which aggregates millions of opinions into a single price, can know exactly what the future holds. We can only make reasonable estimates about a range of outcomes.
The reality is that, even if Apple (just to use an example) is priced at $116.45 a share, there's a range of prices that would be reasonable to pay.
It might be reasonable to pay $110 a share, or $120. Either probably makes sense given the range of potential future outcomes.
Thinking of values this way should change how you react to short-term volatility.
When a stock goes up or down, even by a few percentage points, there's a tendency to think the market is trying to tell you something. That it's signaling your company is worth less, or more, than it was a day ago, or a few weeks ago.
But that's rarely the case.
The majority of stock movements are just random wobbles within a reasonable valuation range. Apple shares falling from $116 to $112 might not mean anything at all. It might just mean that shares are probably worth something between $110 and $120, and anything within that range means more or less the same thing.
"But nobody thinks about markets that way," Salmon said. "Although they should."
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