The story is told of a Seeker of Knowledge who sets off in search of the answer to a question that has unsettled him for quite some time. In his extensive travels, the Seeker of Knowledge hears of two wise men who are said by many to be very knowledgeable and experienced in such matters.
The first, a famous guru lives in an ivory tower at the top of a serene mountain high above all the hustle and bustle of everyday life. After a strenuous climb, the seeker reaches the top of the mountain, finds the sage inside his tower and poses his burning question, “What is a stock worth?” The guru answers immediately, “The value of a stock is the sum of all the projected future cash flows in perpetuity, discounted back at an appropriate discount rate which factors in the risk premium and interest rates."
The guru says, "It is quite easy to prove that the stock value = CF/(1+rp + i)^1 + CF/(1+rp + i)^2 + CFn(1+rp + i)^n …”
The Seeker of Knowledge is impressed with this answer, as it seems pretty exact, albeit a bit complicated. The seeker is extremely grateful for this valuable information, warmly thanks the Wiseman, and goes on his way.
The second Wiseman lives in the middle of a bustling city surrounded by a constant swirl of activity and noise. The seeker is fortunate to get in front of this second guru and is able to pose the same question he asked of the first guru, “What is a stock worth?”
Like the first guru, the answer is immediate, “That depends. Are you buying or selling?”
Not knowing quite what to say the seeker starts to respond by repeating the words and equation of the first guru but he is quickly interrupted with, “I don't care about all that stuff, tell him to make me a bid then we can talk about what the stock is really worth.”
A bit confused and not at all sure the wise men's answers have brought him any closer to enlightenment the seeker goes away to contemplate further on this question.
This parable offers two very different answers to the same basic question. The distinction between them reflects the not often recognized difference between valuation theory and actual stock prices.
The Discounted Cash Flow Valuation Model above and others like it, are theories that try to derive the value of a stock so that is it is mathematically consistent with the inputs. These valuation models are forced to make many assumptions. In this case, assumptions such as:
Accurately coming up with these three inputs alone is a herculean feat and shouldn’t be underappreciated.
There is quite a lot of value in thinking about stock valuation and pricing as a range of rational possibilities, because the process is a blending of part science and part art.
-Paul R. Rossi, CFA
You might ask, what does a picture of a blackhole have to do with the article? Absolutely nothing, I just like the picture. :)
The parable above has been modified from a 1989 Financial Analysts article Journal written by Professor Stephen Figlewski of NYU. The original article pertained to Option Valuation and Pricing.
Paul R. Rossi, CFA