It's Future Cash Flows, Stupid!
From The Financial Times newspaper:
Link to original Letter at FT.com
It’s future cash flows, stupid!*
Published: November 24 2007 02:00 | Last updated: November 24 2007 02:00
From Mr Logan Flatt.
Sir, It is no surprise that an academic study overlaying fundamental company data with equity market data (Long View, John Authers, “Number-crunchers are socially desirable again”, November 17) would conclude that reported earnings or earnings forecasts are the “best predictor” of the market’s valuation of a publicly traded company. After all, the market’s “valuation” represents the market pricing the company’s shares based on supply and demand.
Holding supply constant, market price is determined at the margin by speculative demand for the shares. Most speculators probably formulate their demand for the company’s shares based on a mixture of its most recent quarterly earnings report, analysts’ forecasts of future earnings, unofficial Wall Street whisper earnings, and random online chatter. In the spirit of “group think”, it is entirely possible that most speculators give more weight to earnings measures simply because more people in the market talk about earnings measures than cash-flow measures.
Ah, but there’s the rub: the objective and reasonable valuation of a company has little to do with the supply of and demand for the company’s shares and everything to do with the company’s ability to generate future cash flows. Many successful investors have proven records of using cash-flow-based valuation approaches to uncover and then take advantage of compelling investment opportunities that have exceeded historical market index returns.
They gained their advantage by using estimated future cash flows to assess a company’s intrinsic value – the economic benefit today of holding onto the company’s shares over the long term for the sole purpose of collecting future cash flows from the company – and then asking themselves: “What price am I willing to pay for the company’s shares today given the economic benefit the company’s shares offer me today?”
A quick look at the ticker tape told them whether or not it was prudent to pay the prevailing market price for the company’s shares. If the company’s prevailing market price exceeded the company’s intrinsic value, these successful investors likely took no action. If the company’s prevailing market price fell well below the company's intrinsic value, they probably committed significant capital to the investment opportunity and never looked back.
I submit that speculators’ focus on the company’s near-term earnings measures probably created the short-term market inefficiency that led to the mispricing of the company’s shares vis-a-vis their intrinsic value. Furthermore, I submit that long-term market efficiency probably ensured the successful investors' market-beating returns since, to paraphrase Benjamin Graham, the market is a voting machine in the short term, but a weighing machine in the long term.
Logan Flatt,
PowerWealth.com,
Dallas, TX 75230, US
Copyright The Financial Times Limited 2007
*NOTE: Title chosen by The Financial Times, not Logan Flatt.
Copyright 2007 PowerWealth.com. All rights reserved.
