How to Beat the Market Without Gambling

Rationales behind value investing (by Fan)

The US stock market has been hot since COVID 19 happened. Many retail investors joined the market and started trading during this unique WFH period. However, it’s not surprising to me that many of them do not understand what’s the difference between “gambling” and “investing”. Therefore, I decided to share some basic knowledge about stock investing. The diagram above should be self explanatory. But I will still give more explanations on the following five topics. Feel free to skip certain sections if you already understand the concepts well.

  1. Fair Value: What’s fair value? Why is this important?
  2. Stock Price: Why does stock price change over time?
  3. Investment Return: What will determine your investment return?
  4. Opportunities: Where could you make money with low/no risks?
  5. DCF Model: What’s the rationale behind DCF (Discounted Cash Flow) models?

Summary

  1. In an efficient market where most investors are rational and sophisticated and have access to all available information, the stock price should always reflect the fair value of the underlying asset. An investor can make money if (1) he/she has better information than other investors – he/she gets a different fair value of stocks with better information, sees a gap between the real fair value that he/she believes in, and makes money by closing the gap; (2) he/she has better financial modeling skills than other investors – he/she gets a different fair value of stocks with a better valuation model, sees a gap between the real fair value that he/she believes in, and makes money by closing the gap; (3) he/she bets on that the stock price will change due to unexpected future events, and he/she makes money by betting on future favorable events.
  2. In an inefficient market where there are many irrational investors, an investor can make money by finding the gaps between “fair value” and “market price”. These gaps can come from (1) irrational investors react slowly to the updated fair value of stocks after unexpected events happened; (2) irrational investors do not accept the fair value at all and purchase stocks at random prices; (3) there is no clear fair value for some new disruptive businesses, and a potential gap exists between the stock price and its real fair value, which is unclear.
  3. Rational investors should always make money by finding and closing the “fair value” – “market price” gaps instead of (1) betting on unpredictable future events; (2) being overconfident and easily believing that he/she has better information/financial modeling skills than the other rational investors; (3) or investing based on fake correlations/causations drawn from historical trading patterns.

TL;DR

Fair Value

According to investopedia, in the broadest economic sense, fair value represents the potential price, or the value assigned, to a good or service, taking into account its utility, supply and demand for it, and the amount of competition for it. Although it infers an open marketplace, it is not quite the same as market value, which simply refers to the price of an asset in the marketplace (not intrinsic worth).

For example, person A is willing to buy an egg for $1 based on his perceived value of this egg. Here, person A gives a fair value of $1 to the egg. Person B is willing to buy an egg for $2, and $2 is the fair value given by person B. In a market with sufficient rational buyers who have access to all information, we can expect most people come up with a fair value for this egg within a small range (e.g. $1-$3, normal distribution), and therefore the fair value of the egg given by the market is about $1-$3.

However, at certain point, there is a supply of 100 eggs on the market, while there are 2 chefs who really need 200 eggs to cook some dishes and would like buy the eggs at a price of $20 each (these two chefs are irrational buyers). The market price of the egg will be $20 until the 200 demand has been fully met.

Therefore, the $20 market price does not match the fair value ($1-$3) given by the majority of the market players – those rational buyers.

It sounds easy to come up with a fair value for an egg. However, how can we give a fair value to a business? Think about this scenario: if you want to buy a chicken as an investment, what is the highest price you would like to pay for it?

You will firstly want to calculate how much money the chicken can bring to you. The chicken can produce 100 eggs per year, you can sell the eggs at $1 each at the end of each year, and the chicken can live for 3 years. Therefore, you can make $1 * 100 = $100 from this chicken every year, and the “lifetime value” of this chicken should be $100 + $100 + $100 = $300. But there’s a small flaw here – we have not considered the time value of money.

If we take into account the value of time, $100 in one year values less than $100 at present. Choosing between $100 now and $100 in one year, a rational person should always choose $100 now as he/she can put it into a bank and get some interest (e.g. 2%) in one year. Therefore, $100 now should value $100*(1+2%) = $102 in one year. Therefore, the present value of the second option ($100 in one year) should be $100/(1+2%) = $98.04.

Therefore, the fair value of the chicken should be $288.39 instead of $300 because $100/(1+2%) + $100/(1+2%)2 + $100/(1+2%)3 = $98.04 + $96.12 + $94.23 = $288.39. If you are paying more than $288.39 for this chicken, you are very likely going to lose money.

It is very similar to value a business compared to valuing a chicken. You calculate how much profit the business can generate for you every year during a reasonable lifecycle, calculate the present value of those future profits, sum up these present values of the future profits, and then you know the fair value of this business.

For stocks, investors will estimate the fair value of a company based on how much profit they estimate the company can make in future years during its lifecycle. However, the market price does not necessarily always reflect the fair value.

The efficient-market hypothesis asserts that, in a well organized, reasonably transparent market, the market price is generally equal to or close to the fair value, as investors react quickly to incorporate new information about relative scarcity, utility, or potential returns in their bids; see also Rational pricing.

Behavioral finance asserts that the market price often diverges from fair value because of various, common cognitive biases among buyers or sellers. However, even proponents of behavioral finance generally acknowledge that behavioral anomalies that may cause such a divergence often do so in ways that are unpredictable, chaotic, or otherwise difficult to capture in a sustainable profitable trading strategy, especially when accounting for transaction costs.

In reality, particularly in the year of 2020 when a lot of retail investors – most of whom are irrational investors – joined the market, the market is not always efficient, the efficient-market hypothesis no longer holds, the behavior finance theories explain the market better, and the stock price will diverge from the fair value, leaving opportunities for the sophisticated/smart investors to make money at low/no risk.

If you are interested in learning more about how a company’s fair value is measured, feel free to read the last section of “DCF Model”.

Stock Price

As mentioned in the last section, the fair value of a business reflects investors’ estimates about the business’ profitabilities in the future years of its lifecycle. Investors try to incorporate every piece of available information in their projection and valuation models, and these estimates should have already been the most accurate estimates that human beings can make.

However, with unpredicted events happening and future events happen differently compared to what’s expected, the fair value of a company will be updated all the time. When a company is outperforming investors’ expectations (e.g. has acquired more users in one quarter than it was expected by the investors), the company’s fair value will be updated (increased) because investors will update their valuation model and have an updated projection about the company’s future profitabilities. Once the fair value is updated, the stock price will quickly (in an efficient market) update and increase to reflect the new fair value.

Hence, the change of stock price actually comes from the gap between “expectations” and “realities” but has little to do with its absolute financial numbers.

For example, investors expect company A to grow 4M users in Q3 2020 and have factored this assumption into their existing valuation models. Based on the estimates, investors give company A a fair value of $60 per share. The stock price is also $60 per share as it reflects the fair value. During the company’s Q3 financial release, holding everything else constant, if the company has acquired 4M users in Q3, the stock price should not change regardless of if the company has a much higher growth than its competitors or not, if the company is ranked the largest player in the market or not, or if the company is making money or not.

Similarly, if company A was expected to grow 4M users in one quarter but has acquired 6M users in that quarter, the company’s fair value will be updated and increased, and the company’s stock price will also be updated and increased to reflect the new fair value.

Investment Return

In an efficient market, the stock price should always reflect the most updated fair value of the stock. Therefore, assuming no unexpected events happen in the future and therefore stock fair value and price don’t get updated, investors will make no return since they are buying an $10-value asset at the price of $10.

However, as mentioned above, the market is not always efficient. The market price is not always reflecting the fair value, and there could be a gap between the market price and the stock’s fair value.

Why would there be such gaps? The market can be inefficient and have those gaps for many reasons:

  1. There will always be unexpected events, and investors’ estimates of future events and probabilities cannot be 100% accurate. Therefore, the fair value will frequently get updated, and the stock price will also change due to the changes of fair values. When this happens, it takes time for investors to react and close the gap. When an unexpected event happens, the sophisticated and rational investors will incorporate the new information into the valuation model and give an updated fair value. However, it will take seconds, hours, or even days for the market (all the investors on the market) to accept this price and reflect the new fair value. This is one reason why there can be a gap between “fair value” and “market price”.
  2. There are many irrational investors, and they do not accept the fair value. For example, if there are many irrational retail investors who are not sophisticated at all, these investors will probably buy a $10-value asset at $20, pushing the stock price to $20 (think about the $20 per egg example at the beginning). For example, these investors don’t understand the fair value of a stock ($20 per share), which is traded at $10 per share, and they mistakenly think the stock is overpriced and do not buy it. This is another reason why there are such gaps on the market. The more irrational investors on the market, the more gaps there could be.
  3. Lastly, there might not be a clear fair value. For some new industries, a business is very unique and new, and investors find it difficult to estimate its fair value. In this case, there can be a gap between the company’s stock price and its fair value. For example, no one really knows what the fair value of Tesla or Ant Group should be. Therefore, there is a potential gap between the market price and the stock’s real fair value, which is unclear.

Therefore, what determines an investor’s investment return? It’s the gap that he/she is trying to close. If the gap is big enough and it’s closed quickly, the investment return will be very high. On the other side, if the gap is very small and it takes a very long time to close – the market reacts very slowly and is very inefficient, the return will look poor.

Opportunities

As mentioned above, in an ideal efficient market, the stock price should always reflect the fair value of its underlying asset. Therefore, investors will possibly make zero return by trading stocks at its fair value, if no unexpected events happen. In our real life, unexpected events could happen, fair value and market price will get updated, and investors can make/lose money from these unexpected events. However, betting on unexpected events is not investing but gambling.

In my opinion, a rational investor should only invest by closing the “fair value – market price” gaps. The market is not always efficient, and the gaps can exist. For example, in late October, most leading equity research firms (sophisticated and rational investors who have access to all available information) give Square (Ticker: SQ) a target price of $210 – $215, while the stock price of SQ during those weeks was $160 – $180, and there is a gap of at least $30 (indicating a ~17% short-term return). For example, in late November, most leading equity research firms give Sea (Ticker: SE) a target price of $210 – $215, while the stock price of SQ during those weeks was $175 – $185, and there is a gap of at least $25 (indicating a ~13.5% short-term return).

Investors should always be cautions about the fake opportunities. Some investors tend to believe that they have better knowledge/information about a company than a collection of sophisticated/smart investors in the market. In some rare cases, it can be true. But in most cases, the sophisticated investors should already have the best talents to build the most sophisticated financial projection models, have access to all available information, and have incorporated those information into their valuation models. People should be very cautious to think this way, since it is dangerous to assume other investors are not as knowledgable as you, easily think the fair value is different from what the market gives, and see a fake “gap”.

DCF Model

This section gives you a very quick explanation of how DCF (Discounted Cash Flow) model works. Discounted Cash Flow (DCF) method is commonly used in both the private market and the public market. The simple idea behind this method is to value a company based on how much money the company can make in the future.

For example, assuming Company A can generate a net profit of $100 per year and it is going to generate the same amount of profit in all future years, the valuation of the Company A can be roughly calculated as follows:

Valuation of Company A now = Profit (year 1) + Profit (year 2) + Profit (year 3) + … + Profit (year N) (N = the number of years that investors believe the company can last)

However, there are two small flaws in this formula. First, not all profit could be returned to investors. For example, Company A may need to reserve more working capital in any of the future years, and the extra reserve will be deducted from the net income from that year. For example, Company A may need to purchase some properties or machinery in any of the future years, and that expense will also be deducted from the net income of that year. Therefore, investors use “Free Cash Flow (FCF)” to replace “Profit” in the last formula to represent the real return that Company A can distribute to investors in future years.

By definition, Free cash flow (FCF) represents the cash a company generates after accounting for cash outflows to support operations and maintain its capital assets. Feel free to read more here about how to calculate FCFs.

Therefore the above formula should be updated to:

Valuation of Company A now = FCF1 (FCF from year 1) + FCF2 (FCF from year 2) + FCF3 (FCF from year 3) + … + FCFn (FCF from year N)

Second, the formula has not taken into account the value of time. It is widely known that $100 received today is more valuable than $100 received next year since people can use this $100 to make more money in one year, for example generating interest by saving this $100 in a bank account. Therefore, assuming an annual interest rate (r) of 2%, $100 today should be equal to $102 next year. Alternatively, the present value (PV) of $100 from next year will be $100/(1+2%) = $98.04 today.

The formula of Present Value (PV) is fairly straightforward: 

PV = FCFn/(1+r)n

Where r is called discount rate, and n is the number of years between now and the time when the FCFn is generated.

Specifically, discount rate r will heavily depend on the cost of capital of each investor. For example, for VC investors, assuming they promise to give at least 15% return to their LPs, the cost of capital will be 15%, and the discount rate r will therefore be 15%. The rationale is that if VC investors do not invest in Company A, they can allocate the capital to some other projects and make 15% return, and therefore 15% is just like the 2% interest rate used in the very first example to calculate present value.

Therefore, the above formula should be further updated to:

Valuation of Company A now = FCF1/(1+r)1 + FCF2/(1+r)2 + FCF3/(1+r)3 + … + FCFn/(1+r)n

When n gets larger, FCFn/(1+r)n gets smaller and smaller. To simplify the calculation, investors give a terminal valuation to sum up the FCFs after a certain number of years (e.g. the sum of all the FCFs after year 30).

The formula of Terminal Value (TV) is: 

TV = FCFn*(1 + g)/(r-g)

Where r is the discount rate, FCFn is the last projected FCF, and g is the estimated growth rate of Company A after many years. For example, investors can estimate Company A’s revenue (or profit) will always grow at a 2% (g) speed after year 30.

Assuming investors sum up the FCFs after year 30, the valuation formula will be finalized as:

Valuation of Company A now = FCF1/(1+r)1 + FCF2/(1+r)2 + FCF3/(1+r)3 + … + FCF30/(1+r)30 + FCF30*(1+g)/(r-g)

Here is a simplified example of how the discounted cash flow valuation method works. Feel free to read more about how the discounted cash flow valuation method works here.

Simple example of DCF-based valuation (by Fan)

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