Thursday, June 26, 2008

The RandomChalice Price

A few days back on CNBC Europe I saw some UBS analyst talking about who is going to win the Euro 2008, no it was not a fun banter; this man had actually constructed a mathematical model!!! to predict this………no wonder UBS is doing so terribly, I really don’t know what value this analyst community actually add……..

Let’s talk about the value of a stock. Frankly there is nothing called a ‘right value’ or a ‘fair value’ of the stock and all these valuation methods of DCF/FCFE etc though may sound very logical but are nothing more than B School lab rats, think about it…………If I ask you about the fair value of the apple in the market, ofcourse you can theoretically calculate it by constructing some exotic utility function and projecting some inflation figures but your answer would be as good or as bad as mine if I wake up early morning and in my half asleep stage just take a guess. So what really matters is ‘Relative Value’

Keeping this thing in mind how should I take a call of investing in a stock, Let’s take the example of ICICI bank, currently ICICI Bank is trading around 800 rupees however at the time of writing this article it was trading around 950 rupees. Now for argument sake let’s assume its earnings growth remains linear at 25% (though I have my reservations over the fact that this bank would be able to keep up with this earnings growth). The reasons:

A banks growth is dependent primarily on its financial capital and human capital. The return on financial capital is going to be very mediocre due to the state of capital markets and the bank itself is scaling down on its employee intake. So with both aspects of growth faltering the earnings momentum of this bank is surely going to take a hit.

The price (P) of any stock is composed of two components:

- Linear price (Lp)
- RandomChalice price (RCp)

═> RCp = P - Lp

When I invest my money in the stock I expect it to grow faster than the money in fixed deposit. Now the PE of ICICI bank in case of the market price of 950 is around 26. Now if I put my money in FD, I can get my principal back in about 8 years. At 20% growth rate any stock

═> P/E = ((1+g)n – 1)/g

So in case of ICICI bank n ≈ 10 yrs

So much longer, at n = 8 years my P/E = 16.5, this implies that this bank warrants a reduction of 36.5% in price, which implies its linear price if approximately equal to around 600 rupees. Any excess price above this is what I call the ‘RandomChalice price’. This is the price we pay for positive surprises in the stock or in other words it’s the price of unknown (this can be due to anything: structural change in business, new invention/discovery, oil find, acquisition, increase in earnings or any other unimaginable thing on the planet or in the universe). At 36.5% this price is too high for this relatively mature stock when many other stocks are available in the market with a very low randomchalice price.

I have taken the benchmark as the return from FD, however the returns from stock should certainly be greater than that of an FD due to the higher risk associated with them (ofcourse a number given to this risk can always be subjected to argument). This is just an example to show how exorbitantly high the price of ICICI bank is.

So essentially after adjusting for the risk any price over and above the linear price is the randomchalice price, if this price is negative then either the stock is too undervalued or the associated risk associated with the stock is too high and you need to adjust your risk adjusted return. This is how one should really judge a stock by its randomchalice price because this what ultimately leads to real wealth creation and through some predictable mathematical model……..

And O! yes by the way that UBS analyst had predict Germany to be beaten by Switzerland in the quarter final, unfortunately Switzerland is out in the very first round so much for the mathematical model……………

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