By DAVID MOON, Moon Capital
September 8, 2002
Every time shares of a stock are traded, there is a buyer and seller.
The price at which they conduct the transaction is the stock market's current
best estimate of the value of those shares. But as we now painfully know,
the market is often wrong. In fact, given the incredible volatility of
stock prices and the constant intra-day fluctuations, the market is usually
During a three-hour flight from New York to Los Angeles, an airplane is off
its precise course about 98 percent of the time. The pilot is making
constant adjustments to keep the plane headed in the direction of Los
Angeles. Almost all of those adjustments are so minor as to be unnoticed
by the passengers. A stock price is the same. Every time a stock
price moves a few pennies per share, the market is adjusting its estimate of the
value of the stock, trying to keep the price moving in the correct direction:
toward its value.
Unlike when a plane reaches its destination, however, a stock is just as
likely to continue past its value and go off course in another direction.
There is no ending point for the stock market. (That is, unless a company
is purchased or goes bankrupt. In these cases, the stock price will
continue to move toward it value - zero in the case of a bankruptcy; the
takeover price in the case of an acquisition - until it arrives at its final
destination. In most cases however, a stock price's journey is never
ending.) And while the value of a company doesn't change rapidly, it will
change. So as a stock price moves towards its value, the price uncertainty
and volatility is made more dramatic by a moving target: changes in the value of
the underlying business.
The price of a stock is an easily observable fact. But what is the
value of a stock?
The value of a company is simply the total amount of cash a business will
generate for its owners over the life of the business, expressed in today's
dollars. The variables are easy to identify:
1) the future cash flows
2) the timing of each of those cash
3) a time value of money factor
If an investor knows each of these three variables with absolute certainty,
he can easily calculate the precise value of that business. That value
would not be constant, however, even if the anticipated future cash flows
remained constant. The value of that business would still be susceptible
to changes in the time value of money factor, which is a function of interest
rates and inflation. As interest rates change, the value of any fixed
income stream also changes.
A business that never generates any cash for its owners is worthless.
Simple. Worshipers at the dot.com altar missed the lesson. The
dot.comaniacs focused on their stocks ' which were really just pieces of paper '
rather than the businesses represented by those pieces of paper. They
falsely believed that a company's value depended on whether or not someone
wanted to buy the stock. If they could anticipate which stocks would be
popular next week (or month or year), they believed the long-term profitability
of a company was irrelevant to its value.
Stock values are not determined by supply and demand. Ben Graham was
right: in the short run the market is a voting machine, measuring the collective
votes cast by buyers and sellers. But in the long run, the market is a
weighing machine, ultimately measuring the value of the businesses represented
by stock transactions.
David Moon is president of Moon Capital Management, a
Knoxville-based investment management firm. This article
originally appeared in the News Sentinel (Knoxville, TN).