4 minute read
WHY VALUATION MATTERS in the end
from FlyWestair May 2021
The 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 23 rd , 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.
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.
If you decided, like everyone else, to buy the stock for N$15 you have paid 50% more than what the company fundamentals suggest it is worth. The company will release results of the profits, and if they are not in line with market expectations the share price will fall. Said differently, the price paid has such high expectations build into it (50% in additional value), that the chances of future profits disappointing market expectations are extremely high. When the market is not happy, it will sell and if there are more sellers than buyers, the price will fall. Continue with this line of thinking and in the end, you will think that the stock market is nothing but a gambling machine.
On the other hand, if you decided to buy that same company during the COVID-19 crisis, you would have bought a sustainable business run by an excellent management team that is able to generate cash for a very long time, but with a potential reduction in profits for 1-2 years (compared to 30 years plus of good cash profits thereafter). At a share price of N$5 you are buying at, let us say, 40-50% less than what it is worth. This means that a safety margin of ±45% provides you with the luxury of being wrong with about 45% of what you think the business is worth and still make your necessary minimum return.
Combine the above train of thought with a diversified basket of businesses with different exposures in the world and your risk is reduced significantly.
The above sounds very simple and logical, right? Then why is it so difficult to do? Life is full of roller coaster rides; things rarely are plain sailing over the long haul. We are allowing our emotions to get dragged into the troughs and peaks to a point where our decisions become nonsensical. Only a disciplined, predetermined plan could assist us to act differently in the moment.
You might be flying somewhere today with a mission to go forward in life, but is your starting base thought through properly? Valuation always matters in the end…
René Olivier
René Olivier(CFA) is the Managing Director of Wealth Management at IJG, an established Namibian financial services market leader. IJG believes in tailoring their services to a client’s personal and business needs. For more information, visit www.ijg.net.
