Explaining Valuation Theory to My Dad

Wed, Jan 5, 2022 5:23 AM on Stock Market, Recommended, Exclusive, Latest,

Article by Bivek Neupane

A couple of days ago a friend of mine asked me about the so-called "factors" that I keep referring to every now and then. When he asked me that question, I was a bit confused. Not because I didn't have a detailed understanding of the topic but because he did not have a finance background.

As soon as he asked me that question, I immediately started thinking - What would be the simplest and best possible explanation regarding these risk factors that will not require any sort of preliminary understanding of financial theories?

After thinking for a while, I think I have come up with an answer. I am going to structure this piece like Plato's dialogue and take the role of Socrates (no, I am not wise like Socrates, but let me have my moment alright!). Also, the other party in this dialogue, my dad is a businessman so he does have a surface-level understanding of things like sources of capital (debt and equity), managing leverage, etc. Hopefully, after having this conversation, he will think about risk and returns in a different way. That being said, let's start from the very beginning.

Alright, dad, you keep asking me about which stock you should buy next. I will answer all of those questions you have asked me until now altogether in this article. But first tell me, what is a stock? 

Dad: "Ughh..!?"

Let me help you with the definition. A stock is simply the value of a firm's book value (the assets that the company basically owns like buildings or IPs) + the discounted value of future cash flows.

Dad: "Wait a minute, what the hell is discounted value of future cash flows?"

A very good question. Let me put it this way. You see a company making good profits and you want to take part in the profit distribution (i.e. dividends). That is the fundamental reason why anybody buys a stock. However, if you buy the stock now, you are buying a series of future profits (these are potential because future profits are not certain). So, essentially, you are paying for those future profits now. 

Dad: "Alright, so how much should I pay for those future profits? Since we are talking about future profits and as you said, those are not certain, how can we know how much to pay?"

Again, excellent question. Thankfully, for that, we have something called a discount rate. The discount rate is simply the rate at which you discount the future profits to decide how much you are going to pay for future profits today. What do I mean by that? I will explain to you the intuition behind discount rates by presenting you with a scenario. Let's suppose you are thinking about buying a stock and since it is well-covered (probably large-cap), you also found major analysts' forecasts for future profits. It says:

15000 after 1 year, 17000 after 2 years, and 20000 after 3 years

Now, I suppose you surely want to take part in that $20000 of profits but how much would you pay for that future $20000 right now? Would you go ahead pay the entire $20000 right now?

Dad: "Absolutely not!"

Why not?

Dad: "Well, because it is after 3 years in the future. This means there can be lots of things happening in 3 years. And, to top it off, those are just projections at the end of the day. There is a chance that it can be wrong."

So, how much would you pay?

Dad: "I don't know. But, I shall definitely be paying less than 20000!"

Ok, dad, I think I have stretched you enough. Let me take on from here now. You are absolutely right in that the future is uncertain and the more in the future the profits are, the riskier they become. Hence we should pay less and less for those profits that are far into the future. Furthermore, time is not the only characteristic of riskiness. Some companies might have bad fundamentals which are reflected in the financial ratios. The future profits of this particular company might also be inherently risky. The main point to note is that you should pay less for risky future profits. Again, risk can come through any means.

Dad: "And, how does the discount rates come into play here?"

The discount rate provides you with the exact amount you want to pay for those future profits. The discount rate is important because it reflects the amount of risk in the cash flows (i.e. future profits). For example, if a company is very safe with an excellent balance sheet, you would apply a relatively low discount rate because you are very likely to get all of those future profits. This means you will pay more for this investment because you are quite certain to get future profits. And, when you pay more for any investment, the expected returns in the future are automatically low. Said in other words, you are expecting a lower return for this particular safe investment. (Remember the old business adage: the more the risk, the more the profits/returns).  

However, if the potential future profits that you are looking at came from a company that is deemed quite risky by the market and also indicated by the accounting data, then you would be thinking, "Jeez, I would definitely not pay more for this crappy looking company". So, yeah if you are paying less, this means you now have higher expected returns. (Note: I am saying EXPECTED returns and not REALIZED returns)

Are you following dad?

Dad: "Yeah, kindaa! I will have to look at my notes for a while. Could we do take a break here? We shall continue after a few days. Let me think about all this info I have received today." 

Alrighty...take it easy!

Bivek Neupane is a recent graduate of MSc. Finance and Economics. His master’s thesis titled “Is more always better? The impact of quality in alpha and factor premia” was focused on analyzing independent risk premiums around the world. He is specializing in quantitative finance and research. If you have any questions, do not hesitate to contact him. You can connect with him via LinkedIn , his blog or e-mail.