The Dividend Cafe - What's in a Stock Price?

Episode Date: February 4, 2022

We are living in interesting times for equity investors, and I have no reason to believe those times will get any less interesting any time soon. But one thing I would love for clients of The Bahnsen Group, and to a lesser extent, all readers of the Dividend Cafe is for there to be an understanding of what equity investors are really after. We all know “buy low, sell high” – and I even wrote a book once on how I think investors ultimately best monetize their participation in the stock market. But I think a little more understanding of what one is paying for when one buys a stock may be useful (which of course, also implies a definition for what they are selling when they sell one). And if I do this right, maybe, just maybe, we will gain a better understanding of how to navigate the next phase of markets. To that end, we work. Jump on into the Dividend Cafe. Links mentioned in this episode: DividendCafe.com TheBahnsenGroup.com

Welcome to the Dividend Cafe, weekly market commentary focused on dividends in your portfolio and dividends in your understanding of economic life. Well, hello and welcome to another week at Dividend Cafe. I am sitting in my house in Newport Beach, not recording the studio this morning because I'm getting ready to go teach uh at the christian high school that i helped to start which is right around the corner from my house i think some of you may have known i've been doing that this semester i've been teaching economics to upper classmen uh and and so i i definitely think that that has given me a whole new appreciation for talking about finance and economics and so forth to clients and investors, because it is much easier doing it to clients and investors than it is to 16 and 17 year old kids. But anyways, I've been back and forth quite a bit lately. I think I've recorded Dividend Cafe

at like five or six different spots so far this year. Last week, I know I was out at my house in the Hamptons. And the week before that, I was at a hotel in Washington, DC. And I've been in both the New York and California studio. So we'll just keep the variety going with different recording spots each week. But what we are doing this week is I think a very fun topic. And I came down this morning to write Diving Cafe several hours before the market opened with no idea what I was going to write about. And I had a few different ideas that I've been playing with the last couple of days. But the reality is sometimes I just kind of get started and then it goes where it goes. And that was one of those days today.

I feel like there's a big need to revisit the kind of elementary subject of what it means to buy a stock price. And how a stock price is valued to begin with. Why do people buy stock in a publicly traded company? And I think the reason for doing this is not because I have this real elevated concern of what's happening in the market day by day right now. And, oh, we had a big up day Wednesday or a down day Thursday, and we're revisiting all these things.

This is like week over week now. Most weeks thus far in 2022, we've had a very similar story. A lot of enhanced volatility, some weeks that were down by a decent amount, and some weeks that were up by a pretty decent amount, but much more volatility than a clear direction, but then a lot of downside in some of the riskier things in the market, and pretty good results in some of the more quality things in the market. And that could be true for one week. It's already proven to be true more than that. And it could end here next week.

I don't know. It's been a number of weeks in a row now, but I don't think it's very important. I certainly don't think it's very interesting. Market volatility is part of market investing. And so to kind of comment on what the volatility created week by week is outside of the scope with what one is mathematically seeking to accomplish as an investor. And it's very tempting for us to just think a kind of pedestrian and sort of stupefied version of why one buys a stock where they just buy it at a price because they hope the price will go higher and they want to sell it at a higher price later. And little munches like buy low, sell high

help reinforce this kind of anti-intellectual understanding of investing. I think it's very counterproductive. Prices are signals. This is something I spent a great deal of time teaching these economic students about at the high school last semester. Prices are signals of information. And contained in those prices is what market actors believe about a whole lot of different variables. Prices tell you things about external circumstances, future expectations, all that type of stuff. And we intuitively know that.

If you are used to going to the store and buying produce and all of a sudden there's a big, big drought or storm and then that week the produce is more expensive, expensive, the price is signaling to you what has happened in the weather and climate that affected delivery of produce goods that week, things like that. Prices with stocks are no different. And yet they are not irrational. They are set by a number of components that we can deconstruct to help understand what is really embedded or ought to be embedded into a stock price. And essentially, what stocks are, are fractional units of ownership that represent a claim on the future earnings and assets of a company. And that's all simple enough. We know that when we own shares of stock, we have this teeny tiny portion of ownership of that company. And that does include voting rights and shareholder rights and proxies

and some input and who's on the board. Sometimes it's supposed to include that. We're ignoring that kind of management function because for practical purposes, We're ignoring that kind of management function because for practical purposes, shareholders really don't think that way or have that in any meaningful magnitude. What we're really referring to is the economics of being a shareholder, which is that you have a unit of ownership on a future claim of the business. And assets are part of that. So in theory, if a company has assets and you think the value of their brick and mortar and their dirt and their factories and their widgets is

going to go higher, and then it does go higher and your units of ownership go higher, that's one reason one may buy stock, is that they think the value of the assets goes higher. But of course, even the assets a company owns usually only go higher to the extent that the productivity of those assets goes higher, meaning the cash flow generation, the earnings that those assets help to create. For the most part, really when it comes down to it, a unit of stock is a claim on the future earnings and cash flows of a business. That's it. That's what you own. And yet, even then, it gets a bit more complicated because there's a couple things we have to explain right now that go into the math of how these things are valued. into the math of how these things are valued. If we know or believe, I should say, that our lemonade stand is going to generate $100 of earnings for the next year, you could say,

well, it's worth $100, except for you gave up something to put that $100 into the lemonade stand. You could have made maybe $2 with your $100 in your bank account. So you have to discount what you gave up to make the investment. And it's what we call a discount rate. It is the opportunity cost. You could have safely made X, but by giving that up to make the investment, that now has to be discounted out of the future earnings. And so you may pay $98 to get $100 of earnings in one year because you had $2 of opportunity cost. But of course, that would just be mathematically the same thing as getting the 2% at your bank account. If you pay 98 to get 2, and you could have made 2 with your 100, it's the same thing, right? You took a risk with the lemonade stand that you don't take in the bank account.

And so in addition to the discount rate, your expected rate of return has to include what we call the risk premium. So effectively, what you pay for future earnings is discounted by the premium. The vocabulary gets complicated, but it's not complicated when you think through it. That premium of what you want from the risk is then reflected in your expected rate of return. So if you think in your lemonade stand that you're going to have the risk of one of the boys in the neighborhood running away with the money, of weather conditions,

of people trying to shut you down because of health concerns, you may say, look, I want an extra $8, an extra 8% because of the risk I'm taking. So you may think you're going to get $100 of earnings, but you're going to pay 90 for it. Eight is the risk premium and two is the risk free rate. Those two things put together get discounted off of the future earnings to give you your present value. That's reasonably simple, I hope. I hope you're following me so far. This is the easiest I can do the math is with a lemonade stand and a hundred bucks and a pretty

simple to define risk-free rate and a pretty simple to define risk premium. The problem is, of course, this is over multiple years. And some, you may say, I think it's going to do $100 in earnings next year, but 105 the year after that, 120 the year after I think it's going to do $100 in earnings next year, but $105 the year after that, $120 the year after that. So you have to apply a growth rate to the earnings and put out a kind of future projection and you discount all of this back into the present at the discount rate and tacking on a risk premium. It isn't very complicated beyond my $100 example with a lemonade stand, other than there's multiple years involved. So yeah, it sounds more complicated, but really it's all very doable mathematically. What makes it more complicated? It's not the math of it. Anyone with a calculator can do it. It's the uncertainty. Once you have more than one year, each year that goes by,

Once you have more than one year, each year that goes by, time is itself an uncertainty. And so it invites more things. What if there's another lemonade stand that comes up and you didn't know about it and you're one, but there ends up being a competitor across the street? What if the discount rate, you think my opportunity cost is 2%, what if that interest rate goes up to 5%? And so forth and so on. So things like inflation, things like uncertainty of earnings, things like circumstantial factors to around a business and its competitors, all of those things factor in together to make the valuation much

tougher. And then of course that has to get priced in to your expected rate of return as well. So at the end of the day, public ownership of an equity is not that different from a lemonade stand, other than there's multiple years, there's a lot of factors that go into the expected earnings. There's a lot of math that has to get done, but the macroeconomics may seem more complicated. The opportunity set of the individual company may seem more complicated, but what you're effectively solving for, this formula is still the same,

which is expected earnings in the future that you're buying, and you're going to pay for those expected earnings, something discounted by a risk-free rate and by a risk premium. That's what stock ownership is. And my suggestion right now is that all four of the factors we care about, calculating future earnings, the discount rate applied to them, the risk premium that one wants for ownership, and the duration of it, how long it takes to realize those earnings. All four of those factors are presently arguing for higher quality companies with more clarity,

more transparency, more durability, more defensiveness, and all four arguing against what the last several years have called for, which was more risk, more uncertainty. As the discount rate has come lower and lower, it has made the value of future earnings higher and higher. And for those companies that their earnings are not right now, they might even be losing money right now, but you have a longer duration view of when some sort of technology company is going to play out. All of those things have played into higher valuations of those more speculative sides of the stock market. And all of those things now argue against higher

valuation for those things going forward. Now, maybe I'm wrong. Maybe the discount rate's not going to change. Maybe people will still believe that their opportunity cost is 0%, the Fed funds rate. Maybe the long duration element that there's just this perpetual patience with the ability of various creative technology, new economy types of companies to get to the point of profitability. But my view is that we've had a very good run in with really low risk premiums, meaning people were expecting, were willing to get a very low differential in what they paid versus the risk they were taking for an eventual result. And they were doing so in a time with a very low risk-free rate, meaning that the discount rate in the economy was so low, the competitive opportunities in the investing landscape. And there was this very high patience level.

It could be way down the line. Some of the big, I think about certain companies that we use their products and services all the time. And they have raised hundreds of billions and tens of billions of dollars and they make no money whatsoever and have no real path to make money. Well, that can be an investment that's worked out for some or not worked out for some.

But my point is, I believe that the patience level or the kind of apathy about those future earnings is coming to an end. I think there will be greater scrutiny about the profitability and then the valuation that one gets. profitability and then the valuation that one gets. Saying I'm willing to wait 70 years to get my money back versus 10 years, 20 years, those things are, I think, in an altering landscape right now. I'm well aware of the fact that most people hearing this could say, I don't think anyone thinks this way. I don't think it's true. People do not think about what the timeframe will be for the earnings to justify the purchase price. They do not think about the discount rate. They do not think about the duration of the equity, how long it will take for these things to play out. They may not, but I believe that markets and other people in the transaction do. And if there are periods of time where they don't,

those periods of time are generally called manias. They're generally periods of insanity. And so it is totally true that one could never think about any of the three or four variables I've talked about, buy something, have it go up in value and sell it, and say, I didn't even have to listen to David's stupid Devon Cafe, and I just made this money. That's all true. All I'm suggesting is that fundamentally, that's not actually what makes a market that there is some rational coherence in the way humans act that eventually plays out in

the numbers. And if we do go through a period of reckoning where the numbers get recalibrated, some things are maybe very cheap and some things are maybe very expensive. And my very strong advice to those that have a portion of their financial goals connected to the equity market, connected to fractional ownership of publicly traded companies is to think about clarity, coherence, fundamentals, value, math right now. I think we are in a paradigm and going into a paradigm where those things will matter again. That's what it means to be a stock investor, my friends. I'm very happy to elaborate on this further. Reach out with any questions. Please rate, review, subscribe, share Dividend Cafe and your podcast player of choice. If you're watching on YouTube

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