September 2024
Issue 5
RATIONAL REFLECTIONS By Bell Institutional
Thinking Backwards
Every day, investors all over the world turn on the television or check their phones to see what the markets are doing. Is the S&P 500 up or down? What about my favorite stock(s)? When people are looking at prices, what are they really doing? Whether they realize it or not (most don’t), investors are actually checking if the market is incorporating their beliefs about the future. At Bell Bank Wealth Management, we believe that stock prices are the best indicator of the market’s future expectations for an investment. We also believe that the price of a stock is nothing more than future cash flows discounted back to the present. Bearing that in mind, it makes sense that the key to successful investing is determining whether the expectations built into a price are achievable and whether or not the market is likely to revise its estimates. If an investor is able to successfully and consistently anticipate revisions in expectations, they will be sipping Mai Tais on a tropical beach in no time!
How Investors Actually Think
In our opinion, the majority of analysts and investors are lazy and short-sighted. Heavy focus is placed on earnings and revenue figures over the recent past or near future (typically last 12 months or next 12 months). While important, the vast majority of a company’s intrinsic value comes from time periods beyond one year. In fact, most valuations result in the majority of company value coming from the terminal value.¹ Along this same vein, sizeable dependence is also placed upon multiples, which typically incorporate the last 12 months’ or next 12 months’ financial figures. This is because they are easy to use and take little time to analyze. Commonly cited examples include price-to-earnings, enterprise value-to-sales and enterprise value-to-EBITDA ratios. Analysts and investors are so reliant on this short-hand version of valuation that nearly all sell-side research reports and the majority of acquisition valuations are based on multiples. However, we do not believe that easier is always better. Besides having a near-term focus, multiples also introduce numerous inconsistencies due to accounting methodologies, which will be covered in a later Rational Reflections piece. To compound the errors of being myopically focused on the near future (past), many “investors” place an even more aggressive set of blinders on themselves and only focus on the next quarter (we call these speculators). This focus on the near-term comes at the expense of developing a coherent picture about what the more distant future (beyond one year) requires in order to substantiate a current stock price. As such, focusing on the short-term is likely to lead to underperformance. Dismissing everything beyond the immediate future (past) leads to flawed valuations and unforced errors. 1