Why Stock Prices Should Never Be the Determining Factor When Making an Investment Decision
I just finished reading a classic investment book "Common Stocks and Uncommon Profits", written by Philip Fisher, a man who had helped shape billionaire investor Warren Buffett’s investing philosophy. In Fisher’s book, there is a passage that lends weight to the idea that investors should not focus on stock prices when making investment decisions.
Here’s Fisher on the topic:
“For some reason, the first thing many investors want to see when they are considering buying a particular stock is a table giving the highest and lowest price at which that stock has sold in each of the past five or ten years. They go through a sort of mental mumbo-jumbo, and come up with a nice round figure which is the price they are willing to pay for the stock. Is this illogical? Is it financially dangerous? The answer to both questions is emphatically yes. It is dangerous because it puts the emphasis on what does not particularly matter, and diverts attention from what does matter”
The passage above from Fisher sums up coherently the crucial concept of not relying on stock prices to make investment decisions. The price of a stock does not tell you anything about the underlying value of the company’s businesses. It says nothing about important aspects of a company such as its prospects and the presence or absence of any competitive advantages.
So, what determines the price, and what determines value?
Price is determined by the supply and demand of a product or the stock. If a product is in demand with limited supply, then the price has to go up. A good example of this would be the meteoric rise in stock prices seen in the last two years (2020-2021) which was mostly caused by an inflow of new investors into the market driving up demand for the stocks and thus resulting in a price increase. Similarly, when these investors leave the market for various reasons, there will be more supply than demand causing downward pressure on the market.
Value on the other hand is determined by three factors: cashflows, growth, and discount rates (affected by inflation and risk premium). One of the most common methods used to do valuation is the discounted cash flow model. This method aims to estimate the current value of a company by determining the present value of its future cash flows. The below image shows the DCF formula.
What causes a decrease in valuation
A decrease in the valuation of stocks can thus occur due to two reasons:
1) A change in the expected future cash flows which results in a decrease in the valuation. The company's cash flow can be influenced by slowing growth due to a recession or a drop in demand for its products due to newer products being introduced by a competitor. This causes the numerator in the formula above to decrease resulting in a decrease in the final DCF number.
2) An increase in the expected discount rate. The increase in the discount rate could be due to inflation, an increase in the risk-free rate, or a need for a higher risk premium. Various factors can lead to an increase in these numbers such as a change in investment sentiment (higher risk premium), increase in bond prices (risk free rate), or sudden disruption in supplies (war etc) which causes inflation. In the model, to adjust for these scenario's, banks will use a higher “discount rate”. This results in the denominator of the formula increasing which results in a lower DCF number.
In short, a stock’s price tells you nothing about its value. If you want to play the investing game well, you need to rely on valuations to determine what price you should pay for a stock. On the other hand, if you want to be a trader, then the price is your friend.
If you like articles like this one, please subscribe to our newsletter to stay updated with our latest articles.
Disclaimer: All opinions shared in this article are the opinions of the authors and do not constitute financial advice or recommendations to buy or sell. Please consult a financial advisor before you make any financial decisions.