Sunday, March 23, 2008

The valuation conundrum and stock market dynamics 2

Continuing with this topic let me add the third variable which we termed as X. The condition was that no exchange was allowed. Well let's just allow such an exhange between gold and bread. Let's say that in this economy there are 10 people, 10 loaves of bread and 10 gold coins. What happens now. As one can see bread is the most precious commodity for people right now, so we would observe that the value of gold would come down dramatically and people would become vary of taking gold as a medium of exchange.
So doesn't this happen in markets. The liquidity dries up, the marignal utility of players shift from investment demand to consumption demand and the there is collapse in valuation of investment related products (the more illiquid the product the faster its fall) leading to a friction in asset markets as various players would tend to resist from accepting such securities as collaterals. This is how basically a market functions, the valuations etc are secondary, however important specially for an investor.
You don't have to go into complex calculations while buying a stock, remember you the real return from the stock comes out of random events, this is what make fortunes. The only research that you have to do is how is the company (because chances of positive random events striking a good company are far greater), don't try to buy stocks that you think are cheap in valuation terms (simply because chances are you would not be able to find very many stocks of this type and even if you do find them the returns would be very limited as they are predictable). However it's important that you also don't buy very expensive stocks. To decide if a stock is expensive or not decide upon your payback period (the period within which you want your investment back) this can depend upon the company, sector, its period of existence etc. Once you decide that take the expected growth rate of the company and see if the investment break evens in the expected time by adding profits of the company for the forward years.
For example lets say a company grows at 20% yoy, adding the various expected earnings for next 7 years would give you a PE multiple of 16.5 [((1+g)^8-1)/g], g is growth rate. Now let's say the current PE multiple is around 16.5 as well. Now you can decide wheter to invest in the stock or not the payback period, the linear growth rate assumed (20%) and component of unpredictibility.
Just remember one thing investing in markets is also like a business (the only difference being that you generally have a negligible or no control) and like in any business getting your investment back is critical, the same holds true in the markets. Ofcourse I am not saying that if calculations say that this stock cannot payback your investment in next 7 years don't invest in it, as you can see there is the assumed component of growth which can vary dramatically due to random events like the comapny entering a new line of business or geography, expanding its capacity much more than expected, getting a very big order etc., all I am saying is that if let's say the PE of the stock is 20 and your calculations gave you 16.5 and you decide to invest in this stock, you are investing on the positive bias of randomness which generally would be the case for most investors. So basically while investing you must know what are you betting on and how much are you paying for the stock's predictibility and how much for the stocks unpredictibility component............

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