### Author Topic: What is the value of stock X?  (Read 10729 times)

#### sthubbar

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##### What is the value of stock X?
« on: March 26, 2014, 05:49:00 AM »
A fundamental concept I learned from Phil Town in Rule #1 Investing is the concept of value.

Let's assume a stock is like a sealed envelope with cash inside.

Most investors purchase these cash envelopes with no idea how much cash is inside and just hope that there is more money in it than they paid.

The amount of money in the envelope is what the stock market lists as the stock price.

Assumptions:

1)  Invest for 10 years
2)  Want 15% return on investment

If I purchase a sealed envelope for \$100 and can't open it for 10 years, how much money must there be in the envelope such that when I open it, I will have made 15% on my \$100?

Answer = \$404.56 (Rule of 72 says 15% should double every 4.8 years so this sounds right)

We want to predict that the value of a \$100 stock in the future will be about \$400.

This is where the interesting discussion starts and I will show how Phil predicts the future value.

The formula is Earning / Share  (EPS) *  Price / Earnings (PE) = Price / Share

We want to predict the Future EPS (fEPS) and Future PE (fPE).  How can we do that?

The calculations for fEPS and fPE will fill take quite awhile to explain and can be found in Phil's book, or we can discuss if really interested.

So, to find out if a stock is a good purchase, I start by predicting how much money will be in the envelop in 10 years based on fEPS * fPE.  If the prediction fPES * fPE = \$400, then is might make sense to pay \$100 for that envelope.  If the prediction is fEPS * fPE = \$200 it makes no sense to purchase this envelope for \$100.  BTW, Phil actually only purchasing stocks for 1/2 this price, so a \$400 future envelope would only be purchase for \$50 or less.

It was asked in another discussion why I though Coke was worth a PE of 6.  I have no opinion about the PE of Coke.  I only want to know what is the future EPS and future PE of the stock and then determine if I will make 15% by purchasing that envelope today.

Make any sense?

#### KingCoin

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##### Re: What is the value of stock X?
« Reply #1 on: March 26, 2014, 07:36:39 AM »
Sure, it makes sense.

However, all stock analysts are playing this game. The question is, why do you think your estimate for future earnings and future P/E ratio are better than other investor's estimates (especially professional investors who spend an enormous amount of time and resources trying to accurately model future earnings)?

#### innerscorecard

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##### Re: What is the value of stock X?
« Reply #2 on: March 26, 2014, 07:41:02 AM »
King Coin, have you read The Most Important Thing? I think Howard Marks' articulation of second-level thinking was the best I've read.

A familiar concept, too, for poker players.

#### arebelspy

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##### Re: What is the value of stock X?
« Reply #3 on: March 26, 2014, 07:57:58 AM »
King Coin, have you read The Most Important Thing? I think Howard Marks' articulation of second-level thinking was the best I've read.

A familiar concept, too, for poker players.

In that vein, have you ever play "Guess 2/3 of the average"?

http://earlyretirementextreme.com/theory-of-mind.html
I am a former teacher who accumulated a bunch of real estate, retired at 29, spent some time traveling the world full time and am now settled with three kids.
If you want to know more about me, this Business Insider profile tells the story pretty well.
I (rarely) blog at AdventuringAlong.com. Check out the Now page to see what I'm up to currently.

#### KingCoin

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##### Re: What is the value of stock X?
« Reply #4 on: March 26, 2014, 08:13:10 AM »
King Coin, have you read The Most Important Thing? I think Howard Marks' articulation of second-level thinking was the best I've read.

A familiar concept, too, for poker players.

I think that most market-moving investors are already using "second-level" thinking. Playing that game well means understanding what market expectations are built into the stock price (for instance earnings growth rates) and how deviations from these assumptions could affect the stock price. You then need to probability weight different outcomes, which is a trick in itself. This is very difficult analysis for an amateur investor.

#### matchewed

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##### Re: What is the value of stock X?
« Reply #5 on: March 26, 2014, 08:15:06 AM »
Why am I suddenly reminded of the poison scene from Princess Bride?

#### arebelspy

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##### Re: What is the value of stock X?
« Reply #6 on: March 26, 2014, 08:30:09 AM »
Why am I suddenly reminded of the poison scene from Princess Bride?

Nth level thinking.
I am a former teacher who accumulated a bunch of real estate, retired at 29, spent some time traveling the world full time and am now settled with three kids.
If you want to know more about me, this Business Insider profile tells the story pretty well.
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#### warfreak2

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##### Re: What is the value of stock X?
« Reply #7 on: March 26, 2014, 12:57:34 PM »
Nth level thinking.
For those who know the "Blue Eyes" logic puzzle, this is why it matters that the oracle says "I see someone with blue eyes".

#### soccerluvof4

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##### Re: What is the value of stock X?
« Reply #8 on: March 26, 2014, 01:10:36 PM »
[The Man in Black has come upon Vizzini holding Buttercup hostage]
Vizzini: I can't compete with you physically, and you're no match for my brains.
Man in Black: [intrigued] You're that smart?
Vizzini: Let me put it this way: Have you ever heard of Plato? Aristotle? Socrates?
Man in Black: Yes.
Vizzini: Morons.
Man in Black: Really? In that case, I challenge you to a battle of wits.
Vizzini: For the princess? [The Man in Black nods] To the death? [He nods] I accept.
Man in Black: Good. Then pour the wine. [Vizzini pours the wine, and the Man in Black pulls out a small packet] Inhale this, but do not touch.
Vizzini: [sniffs] I smell nothing.
Man in Black: What you do not smell is called iocane powder. It is odorless, tasteless, dissolves instantly in liquid, and is among the more deadlier poisons known to man.
[He puts the goblets behind his back and, presumably, adds the poison to one of them, then sets them down in front of him]
Man in Black: All right. Where is the poison? The battle of wits has begun. It ends when you decide and we both drink, and find out who is right... and who is dead.
Vizzini: But it's so simple. All I have to do is divine from what I know of you: are you the sort of man who would put the poison into his own goblet or his enemy's? Now, a clever man would put the poison into his own goblet, because he would know that only a great fool would reach for what he was given. I am not a great fool, so I can clearly not choose the wine in front of you. But you must have known I was not a great fool. You would have counted on it, so I can clearly not choose the wine in front of me.
Vizzini: Not remotely! Because iocane comes from Australia, as everyone knows! And Australia is entirely peopled with criminals. And criminals are used to having people not trust them, as you are not trusted by me, so I can clearly not choose the wine in front of you.
Man in Black: Truly, you have a dizzying intellect.
Vizzini: Wait till I get going! Now, where was I?
Man in Black: Australia.
Vizzini: Yes, Australia. And you must have suspected I would have known the powder's origin, so I can clearly not choose the wine in front of me.
Man in Black: You're just stalling now.
Vizzini: You'd like to think that, wouldn't you?! You've beaten my giant, which means you're exceptionally strong, so you could've put the poison in your own goblet, trusting on your strength to save you, so I can clearly not choose the wine in front of you! But, you've also bested my Spaniard, which means you must have studied, and in studying you must have learned that man is mortal, so you would have put the poison as far from yourself as possible, so I can clearly not choose the wine in front of me!
Man in Black: You're trying to trick me into giving away something. It won't work.
Vizzini: It has worked! You've given everything away! I know where the poison is!
Man in Black Then make your choice.
Vizzini: I will, and I choose- What in the world can that be? [Vizzini points at a rock behind the Man in Black. When he turns to look, Vizzini swaps the goblets]
Man in Black: What? Where? I don't see anything.
Vizzini: Well, I- I could have sworn I saw something. No matter. [He is having a hard time containing his laughter]
Man in Black: What's so funny?
Vizzini: I--I'll tell you in a minute. First, let's drink. Me from my glass, and you from yours. [They drink from their goblets]
Man in Black: You guessed wrong.
Vizzini: You only think I guessed wrong! That's what's so funny! I switched glasses when your back was turned! Ha ha, you fool! You fell victim to one of the classic blunders! The most famous of which is "never get involved in a land war in Asia," but only slightly less well-known is this: "Never go in against a Sicilian when DEATH is on the line!" [He laughs hysterically, but suddenly freezes mid-laugh and dies; the Man in Black removes Buttercup's blindfold]

#### innerscorecard

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##### Re: What is the value of stock X?
« Reply #9 on: March 27, 2014, 01:15:39 AM »
King Coin, have you read The Most Important Thing? I think Howard Marks' articulation of second-level thinking was the best I've read.

A familiar concept, too, for poker players.

In that vein, have you ever play "Guess 2/3 of the average"?

http://earlyretirementextreme.com/theory-of-mind.html

Good post. I find Jacob's posts interesting in general. His forums are also...interesting. They are like these forums but through a glass darkly. A twisted alternate universe that can still in some ways be educational. Jacob's attitude in general is also very interesting to compare to MMM's. Really more of a Sith attitude. Not in terms of being evil, but in terms of being centered around different values despite all the seeming similarities to MMM.

#### innerscorecard

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##### Re: What is the value of stock X?
« Reply #10 on: March 27, 2014, 01:17:53 AM »
King Coin, have you read The Most Important Thing? I think Howard Marks' articulation of second-level thinking was the best I've read.

A familiar concept, too, for poker players.

I think that most market-moving investors are already using "second-level" thinking. Playing that game well means understanding what market expectations are built into the stock price (for instance earnings growth rates) and how deviations from these assumptions could affect the stock price. You then need to probability weight different outcomes, which is a trick in itself. This is very difficult analysis for an amateur investor.

Yes, it comes naturally to professional investors who are used to thinking this way. But if you look at retail investors without financial experience, they seem to invariably engage in first-level thinking - this company is awesome so I should buy the stock! I suspect that part of it also comes from heavily misreading Peter Lynch. He said to buy what you know as a starting point for doing fundamental research and valuation. But people only remember the "buy what you know" aspect.

I find reading http://www.reddit.com/r/investing fascinating for this reason. It is Mr. Market personified.

#### arebelspy

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##### Re: What is the value of stock X?
« Reply #11 on: March 27, 2014, 07:05:57 AM »
Good post. I find Jacob's posts interesting in general. His forums are also...interesting. They are like these forums but through a glass darkly. A twisted alternate universe that can still in some ways be educational. Jacob's attitude in general is also very interesting to compare to MMM's. Really more of a Sith attitude. Not in terms of being evil, but in terms of being centered around different values despite all the seeming similarities to MMM.

Yeah.  I like ERE.  I'm much more Mustachian than Extreme, and MMM's got a fucking way with words.  But ERE holds the soft spot of having introduced me to the concept first.

Jacob is more theoretical, MMM is more practical.

I also find more in common with our forum denizens - ERE lends itself to the doomers and preppers a lot.  They don't get the optimism gun stuff we have.
I am a former teacher who accumulated a bunch of real estate, retired at 29, spent some time traveling the world full time and am now settled with three kids.
If you want to know more about me, this Business Insider profile tells the story pretty well.
I (rarely) blog at AdventuringAlong.com. Check out the Now page to see what I'm up to currently.

#### grantmeaname

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##### Re: What is the value of stock X?
« Reply #12 on: March 27, 2014, 07:38:10 AM »
A fundamental concept I learned from Phil Town in Rule #1 Investing is the concept of value.
I absolutely hate this analogy. It highlights all the moderately important second-order phenomena, but it completely ignores the most important thing about stock investing. The whole story is asinine, because it completely ignores uncertainty. Given all of the market, political, and natural forces facing a multinational conglomerate like [any member of the S&P 500], pretending you can consistently predict the rates of return, timing of any cash flows, and residual value of the company at the time you're ready to sell with more certainty than all the other active investors doing the same thing and outperform just seems naive.

Even the company's CFO is watching their stock price and using it to update his/her guesses of the firm's prospects! Uncertainty is the fundamental ingredient, and any story that ignores it does nothing to build insight.

#### KingCoin

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##### Re: What is the value of stock X?
« Reply #13 on: March 27, 2014, 08:11:17 AM »

Yes, it comes naturally to professional investors who are used to thinking this way. But if you look at retail investors without financial experience, they seem to invariably engage in first-level thinking - this company is awesome so I should buy the stock! I suspect that part of it also comes from heavily misreading Peter Lynch. He said to buy what you know as a starting point for doing fundamental research and valuation. But people only remember the "buy what you know" aspect.

I find reading http://www.reddit.com/r/investing fascinating for this reason. It is Mr. Market personified.

Yes. But I don't see why the superficial "I think this is a good company, I'm going to buy the stock" is inferior to the second order analysis "other people think this is a good company, therefore I will avoid the stock". Both completely ignore valuation. The first order analysis would have worked great for AAPL in 2004. The second in 2012. I guess acting in a contrarian manner helps you avoid bubble stocks, but it's still just naive guessing.

Real stock analysis is hard.  Most of these short-cut truisms from wizened gurus seem great as soundbites, but are fairly hollow once you start to dig in.

#### innerscorecard

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##### Re: What is the value of stock X?
« Reply #14 on: March 27, 2014, 08:38:03 AM »
I agree that price and valuation are key. Of course just because something is hated does not make it automatically buy-worthy. If that were true, then technical analysts would be able to print money like no one's business by just looking at sentiment and other such relative nonsense. :)

I think that second order thinking is just a mental model as a starting point to build off of. Just like the efficient market hypothesis and the random walk hypothesis. They're useful tools because they are not how most people think. If an opportunity is super obvious to everyone there has to be some kind of reason (small size, complexity, risk, psychology, etc.) that it isn't "just" a no-brainer.

I of course take your large point as well. A lot of older and more experienced investors assume and say that the skills of valuation are the easy part and that psychology is the harder part. I think that may be because they are used to talking to investment professionals. Most people don't know how to value a company. Hell, I don't think I can do it competently, although I am trying to learn. If you don't know how to value companies then knowing all the psychology in the world won't help you obviously.

I'm still quite early on in my learning journey (in both the hard and soft skills of investing), so look forward to reading more from everyone on this forum about all these things. It's not my career, and I have no illusions I can beat the market. I index. But I find the idea of valuing companies and then having a daily market where you can buy and sell at prices that can be drastically lower or higher than your value (which you are necessarily uncertain about due to all the assumptions you have made) totally fascinating and am looking to learn more in any way I can.

#### DoubleDown

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##### Re: What is the value of stock X?
« Reply #15 on: March 27, 2014, 10:09:07 AM »
I don't get how anyone thinks they can value or pick stocks. But I get why they want to think they can do it. I have only one individual stock in my portfolio, a legacy of shares I got through the company's ESPP when I worked there. I continue to hold it and follow it and understand the company and that industry well, but recognize I have no clue how it will perform. Every time I check it and see the related company news, there are about 5 articles from investment gurus saying how the stock will do well, and another 5 saying how it won't. By definition, half of the experts are wrong at any one time.

None of them have any real clue, and certainly the average investor does not. Even when I worked there and had some "insider" knowledge of the company's prospects, I had no clue how the markets would value it. There are so many variables, and they're all already priced in as KingCoin has reliably pointed out. And even then, events happen all the time that throw everything in turmoil (like not getting FDA approval for a biotech firm, or being surpassed by an innovative new company or technology, or earnings falling \$.01 short of analyst "expectations", or Russia invades Ukraine, or the founding CEO gets terminal cancer, or...).

#### Otsog

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##### Re: What is the value of stock X?
« Reply #16 on: March 28, 2014, 01:03:59 AM »
Make any sense?

No.  "Calculating" fPE is completely useless.  "Calculating" fEPS doesn't make sense and likely does more harm than good.

This whole strategy seems backwards in that you know what number you need to be spit out at the end of the calculation.  You run a major risk at falling prey to confirmation bias.

#### hodedofome

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##### Re: What is the value of stock X?
« Reply #17 on: March 28, 2014, 04:08:59 PM »
I don't get how anyone thinks they can value or pick stocks. But I get why they want to think they can do it. I have only one individual stock in my portfolio, a legacy of shares I got through the company's ESPP when I worked there. I continue to hold it and follow it and understand the company and that industry well, but recognize I have no clue how it will perform. Every time I check it and see the related company news, there are about 5 articles from investment gurus saying how the stock will do well, and another 5 saying how it won't. By definition, half of the experts are wrong at any one time.

None of them have any real clue, and certainly the average investor does not. Even when I worked there and had some "insider" knowledge of the company's prospects, I had no clue how the markets would value it. There are so many variables, and they're all already priced in as KingCoin has reliably pointed out. And even then, events happen all the time that throw everything in turmoil (like not getting FDA approval for a biotech firm, or being surpassed by an innovative new company or technology, or earnings falling \$.01 short of analyst "expectations", or Russia invades Ukraine, or the founding CEO gets terminal cancer, or...).

There are obviously some people who can do it, but it's not easy. Just because you or I can't do it, doesn't mean it's impossible. Just like nobody on this forum can shoot 5 under at Augusta, doesn't mean it can't be done by anyone. It requires thousands of hours of deliberate practice which most aren't willing to do. Buffet and Munger read hundreds of pages of material each day. At least 80% of their workday is spent reading. That is different from 99.99% of would be investors out there.

That said, being able to value companies doesn't mean you can now make a ton of money picking stocks. You'll see that the return distribution for most investors is the same. About 10-20% of their stock picks paid for 80% of their returns over the years. Just a few stocks at the right time have made up most of the money that Buffet and Munger have earned over the years. Therefore, intelligent risk management to lose as little money as possible when you are wrong, and buying in big when you are right, will make the difference between outperforming an index and being a dud.

It is true that nobody can predict the future. Each trade, isolated on it's own, is random. There's no way for you to know if it will be right. Therefore cutting losses quickly and holding winners for as long as possible is the secret to most successful strategies.

#### Johnny Aloha

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##### Re: What is the value of stock X?
« Reply #18 on: March 28, 2014, 05:26:33 PM »
Thank goodness for low cost, broad market index funds.

#### foobar

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##### Re: What is the value of stock X?
« Reply #19 on: March 28, 2014, 07:51:59 PM »
I skip the calculation and just take the current numbers and add -50% to +400%. It is about as accurate.

Make any sense?

No.  "Calculating" fPE is completely useless.  "Calculating" fEPS doesn't make sense and likely does more harm than good.

This whole strategy seems backwards in that you know what number you need to be spit out at the end of the calculation.  You run a major risk at falling prey to confirmation bias.

#### grantmeaname

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##### Re: What is the value of stock X?
« Reply #20 on: March 30, 2014, 06:55:40 AM »
There are obviously some people who can do it, but it's not easy. Just because you or I can't do it, doesn't mean it's impossible. Just like nobody on this forum can shoot 5 under at Augusta, doesn't mean it can't be done by anyone. It requires thousands of hours of deliberate practice which most aren't willing to do. Buffet and Munger read hundreds of pages of material each day. At least 80% of their workday is spent reading. That is different from 99.99% of would be investors out there.
It seems clear that if you practice at golf you will get better at it. There is no evidence that skill can make you pick stocks that do any better than the stocks you don't pick.

#### hodedofome

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##### Re: What is the value of stock X?
« Reply #21 on: March 31, 2014, 08:57:02 AM »
There are obviously some people who can do it, but it's not easy. Just because you or I can't do it, doesn't mean it's impossible. Just like nobody on this forum can shoot 5 under at Augusta, doesn't mean it can't be done by anyone. It requires thousands of hours of deliberate practice which most aren't willing to do. Buffet and Munger read hundreds of pages of material each day. At least 80% of their workday is spent reading. That is different from 99.99% of would be investors out there.
It seems clear that if you practice at golf you will get better at it. There is no evidence that skill can make you pick stocks that do any better than the stocks you don't pick.

Huh? So what evidence are you citing that practicing golf makes you better at it? The fact that there are people who are shooting lower scores after lots of practice? Well what's the difference between that and the trader/investor that makes more money after practicing their trade?

#### arebelspy

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##### Re: What is the value of stock X?
« Reply #22 on: March 31, 2014, 09:09:28 AM »
Well what's the difference between that and the trader/investor that makes more money after practicing their trade?

[Citation* needed.]

*Non-anecdotal.
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#### grantmeaname

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##### Re: What is the value of stock X?
« Reply #23 on: March 31, 2014, 11:46:27 AM »
The fact that there's no evidence that practicing makes you more money is the difference.

#### hodedofome

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##### Re: What is the value of stock X?
« Reply #24 on: April 01, 2014, 12:10:06 PM »
You are trying to prove a negative which is really hard to do.

I'm not going to dig up all the evidence to prove it. There's plenty of folks out there that have provided proof. You might say that the sample size is not large enough, but that's exactly the point. Only a few people in the world are good enough to compete on the PGA tour. Only a few people in the world are good enough to beat the markets hand over fist in their lifetime. My response was to Doubledown who wondered how anybody could think they could value or pick stocks. There are obviously some who can. Not many, but a few.

If you want to believe that markets are always efficient, and there's no way to do better than the market portfolio, that's fine. I won't try to convince you and I really don't care what you choose to believe. Funny how Paul Samuelson preached EMH at MIT while investing in Buffet along the way...

#### grantmeaname

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##### Re: What is the value of stock X?
« Reply #25 on: April 01, 2014, 12:23:47 PM »
You are arguing "all of the people who picked stocks and did better than the market did better than the market".

#### arebelspy

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##### Re: What is the value of stock X?
« Reply #26 on: April 01, 2014, 12:24:24 PM »
You are trying to prove a negative which is really hard to do.

No, we're asking you to prove a positive: data on investors practicing their craft and beating the markets.

Proving a negative would be the opposite, for us to prove it can't be done.  We can't prove that, but we can say there's no evidence supporting that it can be done.

There's plenty of folks out there that have provided proof.

[Citation needed.]

You might say that the sample size is not large enough, but that's exactly the point.

Sounds like you need to read up on survivor bias and the law of large numbers.
I am a former teacher who accumulated a bunch of real estate, retired at 29, spent some time traveling the world full time and am now settled with three kids.
If you want to know more about me, this Business Insider profile tells the story pretty well.
I (rarely) blog at AdventuringAlong.com. Check out the Now page to see what I'm up to currently.

#### arebelspy

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##### Re: What is the value of stock X?
« Reply #27 on: April 01, 2014, 12:25:51 PM »
You are arguing "all of the people who picked stocks and did better than the market did better than the market".

Well.. that IS true...
I am a former teacher who accumulated a bunch of real estate, retired at 29, spent some time traveling the world full time and am now settled with three kids.
If you want to know more about me, this Business Insider profile tells the story pretty well.
I (rarely) blog at AdventuringAlong.com. Check out the Now page to see what I'm up to currently.

#### hodedofome

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##### Re: What is the value of stock X?
« Reply #28 on: April 01, 2014, 08:54:03 PM »
I like Buffet's example when talking about outsized returns and survivorship bias/randomness of results. If you had a national coin flipping competition you would have some people who win but it would be completely random. But what if all the folks that won came from the same city? You wouldn't expect that and that would be far from random. Graham and Dodd wrote the bible on individual stock investing and any value investor out there would say that they come from the same 'city' as those two guys. http://www4.gsb.columbia.edu/null?&exclusive=filemgr.download&file_id=522

I won't provide any more proof than this. I've got better things to do with my time and you are more than welcome to sift through the SSRN database if you feel the need for additional data.

#### arebelspy

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##### Re: What is the value of stock X?
« Reply #29 on: April 01, 2014, 09:12:50 PM »
If you had a national coin flipping competition you would have some people who win but it would be completely random. But what if all the folks that won came from the same city? You wouldn't expect that and that would be far from random.

It wouldn't phase me.  Even if you find it odd, it should be slightly surprising at best.

Are you actually telling me that if we did have a national coin flipping competition and the two people in the finals were both from, say, Memphis, or Souix City, or whatever, you'd think it was evidence of non-randomness?
I am a former teacher who accumulated a bunch of real estate, retired at 29, spent some time traveling the world full time and am now settled with three kids.
If you want to know more about me, this Business Insider profile tells the story pretty well.
I (rarely) blog at AdventuringAlong.com. Check out the Now page to see what I'm up to currently.

#### warfreak2

• Handlebar Stache
• Posts: 1136
• Location: UK
##### Re: What is the value of stock X?
« Reply #30 on: April 02, 2014, 03:43:54 AM »
Even if the top 100 contestants were from Memphis, I wouldn't take it as evidence that anyone is better at flipping coins - but it would be pretty strong evidence that someone is selling biased coins in Memphis.

(I'm not really taking a side, just applying Occam's razor).

#### grantmeaname

• CM*MW 2023 Attendees
• Walrus Stache
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• Cast me away from yesterday's things
##### Re: What is the value of stock X?
« Reply #31 on: April 02, 2014, 06:16:00 AM »
you are more than welcome to sift through the SSRN database if you feel the need for additional data.
"Here's the name of a site on which some finance professors publish papers" is not the same as "the following evidence supports my position". Especially when it's a question that's not entirely settled in the literature, and when the dominant view is the one against yours.

EMH is 130% true. If you don't believe me, look on JSTOR.