• These are the companies to put on your watchlist. read here

Are stock valuations naturally biased upwards?

11102019_Valuations

Are stock valuations naturally biased upwards?

Conventional wisdom and historical evidence support the observation that “stock prices always go up over time”. On a long enough timeline, stock returns of substantially all developed countries have been positive, driven by inflation and real GDP growth if nothing else.

Businesses are created and fail, and individual stocks enter and exit market indices all the time, but the aggregate “market” of thousands of stocks is expected to grow into perpetuity. Unfortunately for stock-picking investors, the conventional methods used to value individual stocks also embed this expectation, often to the detriment of investment returns.

Recently, Morgan Stanley published a report on the UK retail sector exploring this idea of structural overvaluation. Of the 19 stocks in the FTSE 350 General Retail Index in January 2007, only four remain in the index today. Five stocks disappeared due to corporate actions, which means ten of the UK’s largest listed retailers either went into administration or shrank out of the FTSE 350 over the course of 12 years. Granted, the retail industry globally has seen significant upheaval in recent years due to e-commerce, but even so the attrition rate (over 50 per cent) stands in stark contrast to the idea that “stocks” generally go up over time.

If we rewind back to 2007, it is almost certain that these retailers were being valued by the market on either multiples (e.g. P/E) or DCF basis (or both). The problem with both methods is that they assume the stock being valued trades profitably into perpetuity, which is a fair assumption for the entire market but not for any individual stock. If we take multiples to be a shorthand proxy for DCF, we are effectively capitalising a flat stream of earnings into perpetuity at a discount rate that is the inverse of the multiple applied. The DCF methodology, which allows for greater flexibility in forecasting cash flows, typically incorporates a terminal value at the end of the forecast horizon – which also effectively assumes the business being valued trades profitably into perpetuity. This can be especially misleading when, as is often the case, the terminal value accounts for half or more of the enterprise valuation.

Fast forward 12 years and we can see that this embedded assumption of any individual stock trading profitably into perpetuity is clearly overoptimistic. Investors need to think carefully about which businesses deserve to be valued on a “forever” basis and which ones are likely to decline well before then. Growth businesses in industries with structural tailwinds may have a longer life cycle than mature businesses in declining industries. It is by no means easy to predict whether a business will be around forever, but that doesn’t mean investors shouldn’t consider the propriety of terminal values or multiples on a case-by-case basis.

INVEST WITH MONTGOMERY

Daniel Wu is a Research Analyst at MGIM. Prior to joining MGIM in June 2016, Daniel was an analyst in the investment banking divisions of UBS and Goldman Sachs, where he covered the Infrastructure, Utilities, Technology and Media sectors.

This post was contributed by a representative of Montgomery Investment Management Pty Limited (AFSL No. 354564). The principal purpose of this post is to provide factual information and not provide financial product advice. Additionally, the information provided is not intended to provide any recommendation or opinion about any financial product. Any commentary and statements of opinion however may contain general advice only that is prepared without taking into account your personal objectives, financial circumstances or needs. Because of this, before acting on any of the information provided, you should always consider its appropriateness in light of your personal objectives, financial circumstances and needs and should consider seeking independent advice from a financial advisor if necessary before making any decisions. This post specifically excludes personal advice.

Why every investor should read Roger’s book VALUE.ABLE

NOW FOR JUST $49.95

find out more

SUBSCRIBERS RECEIVE 20% OFF WHEN THEY SIGN UP


Post your comments