"That is one of the mysteries of our business, and it is a mystery to me as well as to everybody else. We know from experience that eventually the market catches up with value. It realized it in one way or another." - Benjamin Graham
Lately, I have been disillusioned by the notion that markets will eventually revert back to the true value of any common stock. People who have done valuations before would understand, that to do a proper valuation of any stock is not easy as it seems. For equity valuation is indeed a truly complex business.
Intellectually speaking, the true value of common stocks of course should not be found by reference to the price movements but rather by the discounted cashflows of the future without the depending on the vagaries of the markets. However, there are several problems with this conventional valuation technique. The most apparent ones would be the measurement of risk and forecasting.
In terms of risk, current financial literature seems to be moving in the wrong direction. Be it the single-factor CAPM or Fama and French's three-factor model, what most of models attempt to do is simply to explain price fluctuations. What matters the most instead should be the downside risks of the company's future cashflows. My view is that most academics are missing the whole point here. However, I can understand where they are coming from. Few investors have the emotional capacity or ever saw themselves holding a stock for more than five years much less even ten, twenty or thirty years. Moreover, when you sell your stock, your terminal cashflow will still ultimately depend on the market price itself at that time.
Secondly, there is a problem of developing good forecasting techniques. In many instances, variations in historical key ratios are too large to create anything that offers good predictive value. The result leads to the creation of an unbelievably large range of prices for any stock, which would be useless in most instances. Most of the time, these ranges would be useless perhaps save for a few rare extreme occasions.
Coupled with ethical and incentive problems prevalent throughout the entire financial industry. It would be extremely rare for anyone to come across insightful, independent and objective valuations. Even if there are, it would be difficult to filter it out from the rest of the noise. Thus, logically speaking there is no way the market as a whole can actually figure out where true value of companies lie. If this were to be the case, then there should be no time limit by which the mispricing of securities can last.
Lately, I have been disillusioned by the notion that markets will eventually revert back to the true value of any common stock. People who have done valuations before would understand, that to do a proper valuation of any stock is not easy as it seems. For equity valuation is indeed a truly complex business.
Intellectually speaking, the true value of common stocks of course should not be found by reference to the price movements but rather by the discounted cashflows of the future without the depending on the vagaries of the markets. However, there are several problems with this conventional valuation technique. The most apparent ones would be the measurement of risk and forecasting.
In terms of risk, current financial literature seems to be moving in the wrong direction. Be it the single-factor CAPM or Fama and French's three-factor model, what most of models attempt to do is simply to explain price fluctuations. What matters the most instead should be the downside risks of the company's future cashflows. My view is that most academics are missing the whole point here. However, I can understand where they are coming from. Few investors have the emotional capacity or ever saw themselves holding a stock for more than five years much less even ten, twenty or thirty years. Moreover, when you sell your stock, your terminal cashflow will still ultimately depend on the market price itself at that time.
Secondly, there is a problem of developing good forecasting techniques. In many instances, variations in historical key ratios are too large to create anything that offers good predictive value. The result leads to the creation of an unbelievably large range of prices for any stock, which would be useless in most instances. Most of the time, these ranges would be useless perhaps save for a few rare extreme occasions.
Coupled with ethical and incentive problems prevalent throughout the entire financial industry. It would be extremely rare for anyone to come across insightful, independent and objective valuations. Even if there are, it would be difficult to filter it out from the rest of the noise. Thus, logically speaking there is no way the market as a whole can actually figure out where true value of companies lie. If this were to be the case, then there should be no time limit by which the mispricing of securities can last.
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