WHY VALUATION MATTERS in the end
T
he patient (economy) got sick from COVID-19 and the doctors (central banks) rushed with an injection (stimulus through money printing) as fast as they could. March 23rd, 2020, was the rock-bottom for financial markets and the uncertainty of a global pandemic sparked the fastest plunge we have seen in our lifetimes. Most people just wanted to get out, and at any price. This created a liquidity crunch, making it difficult for markets to function and therefore a stimulus injection was needed. The dose of the injection thus far is estimated to be 5-7 times the size of the shortfall (hole in the economy created by COVID-19). Life can be an interesting roller coaster and the ups and downs sometimes create adrenaline that clouds our thoughts. The problem is that we get addicted to this feeling and when we reach a new “high”, it is all we can think about. The contrary is also true and the fear of a new “low” creates an anxiety that it will never end. This tendency to extrapolate the recent past into the future makes it difficult to stay rational. When stock prices go up, we expect them to go up even more and when prices go down, all we want to do is to get out. When the rest of the herd is doing the same, this way of thinking makes us feel safe and convinces us that we are making sensible decisions.
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As for making sensible decisions, it would make ‘sense’ to consider what you are paying for your investment. Let’s look at the example of company ABC: Company ABC is generating x amount of after-tax cash per year. Company ABC has a sustainable business model and a management team with an excellent track-record. Company ABC is worth N$10 per share based on fundamental analysis and conservative future assumptions. Now let us assume the following two scenarios: A • The stock price continues to go up and is trading at N$15 per share. • All assumptions are still valid, and no changes have been made to the business model or management team. • The market cannot stop talking about this stock and everyone wants to buy it. B • • • •
COVID-19 hits and the stock price plummets to N$5 per share The market is uncertain about a global health pandemic and the effects on businesses and the overall economy. No change has been made to the business model or management team. Your assumptions point to possibly reduced profits for the next year or two.
