Schrödinger's cat and valuation. Schrödinger stated that if you place a cat and something that could kill the cat (a radioactive atom) in a box and sealed it, you would not know if the cat was dead or alive until you opened the box, so that until the box was opened, the cat was (in a sense) both "dead and alive". This is used to represent how scientific theory works. No one knows if any scientific theory is right or wrong until said theory can be tested and proved. [Source]
In business valuation, the pricing estimates done by analysts can be thought of both right and wrong, until proven by the market via an actual transacted deal between a buyer and seller.
Disclaimer: I've never had much luck with stocks, which is sometimes quite the irony.
I had spent countless hours before formally entering my corporate finance career learning the technicalities and ropes of valuation in hopes of being able to price a company correctly. Even after that, I've spent even more time working on countless models, valuing and running scenario analyses for different companies. Yet, in my poor judgement and over-compensated experience in investment banking, I could never get the pricing of businesses right - at least 90% of the time.
In one meeting ( I shan't say which), I clearly remembered showing a company profile to a client which clearly showed that its share price was trading at historical lows. We were pitching them as a potential acquisition target. Because of its share price (and on hindsight, possibly also the lack of sufficient earnings consensus data), the forward price-to-earnings multiple was so low that mathematically, it was a no-brainer that the acquisition - regardless of how it was funded - would be earnings accretive. Fortunately the client didn't buy them (both the company and the idea) and the stock went into administration / receivership less than a year later.
And you thought bankers had all the brains in the finance world.
Asset pricing is full of bias. For publicly listed companies, so many factors go into the pricing of their stock. Bankers and analysts run their DCF models and communicate valuation to potential investors based on their house view of "realistic growth" - which is pretty much predicated on and driven by the calculated guesses of the target company's CEO and CFO, people whom we trust are in the best positions to comment on an appropriate growth of the business. There's nothing wrong with trusting their numbers, except that this is subject to both experience and motivational bias. Who is to say the numbers are wrong?
"This country needs a vaccine and you are going to have it by end of the year" - says Trump in a CNBC article.
So when someone in a position of power says something like this above, I wonder if the intelligent analysts around the world are going to factor in a scenario of a year-end vaccine in their models.
Trust but verify. If you were smarter or came from the industry, you might be able to validate information coming out from management. Otherwise, you're pretty much left to the mercy of the company's guidance and/or research data done by external parties. Those same data are being gathered by humans on the ground and put together in a systematic and presentable way to be sold at a fee to investment banks and advisory firms. The excel valuation model that you do is basically a output from a "black box" of mathematical functions based on a series of numbers backed by those research. You can run the financial model a hundred times over, but yet you'll never be able to predict and foresee if a business is really valued that much. Why?
Beyond the spreadsheet. The common approaches to valuation for a growth company i.e. the market and income methods - are based almost solely on a single or few data points - next year's and subsequent five years financial estimates. Those future estimates of cash flows often do not take into consideration other critical factors such as:
Cash collected (or more importantly - uncollected) from customers: a commonly overlooked metric in due diligence, found under the detailed notes of trade receivables in the financial statements
Quality of revenues: whether customers really continue to buy the company's products over the longer term (for e.g. Apple)
Geopolitical shocks: as what we are experiencing now with COVID-19, US-China trade tensions, food security, North Korea, changes in political leadership in different countries, etc
All these are compounded by the fact that you are projecting free cash flows over 5-7 years and then applying a "terminal value" to arrive at a valuation. If you do the math, this "terminal value" often takes up 60-70% of the total business value, which means: After pulling all nighters and sitting through detailed interviews sessions with the management on their 5 year plan, and doing extensive research on what drives the industry, you are basically throwing more than half your weight and work into two BIG woozy variables - the long term sustainable growth rate and the weighted average cost of capital.
Apart from the need to have some basis for negotiating deals, I don't believe in the practical application of terminal value to estimate the price tag of a business.
Information is the one big thing that drives the price of a stock. Any unsophisticated retail investor can price a stock even without a properly functioning financial model. If there is proprietary information on a company, not known to the public and is expected to positively impact its outlook, there is a window of opportunity for the investor to profit from it. I am not talking only about proprietary information not only in the form of "insider news" but also proprietary intelligence, analysis and field research. At the end of the day, it is essentially about data collection and scrubbing.
The closer you are to the source, the more confident you become about the credibility of that information - this is information proximity bias. But it does not automatically imply correct-ness. Your belief in that information is personally shaped by your knowledge in the subject matter and the level of trust you (and only you) have in the source.
Many punters and investors get their hands burnt by relying on market rumours without first doing their homework - both in the form of understanding the company and perhaps more importantly, validating the source of that information.
Whenever I receive unsolicited stock rumours and tips nowadays, I tend to assume that this information is already stale i.e. If someone is telling me that this company worth shorting or taking a long position, there is a high chance that this person has already taken a position, and it is also likely that the person before has also done the same, so on and forth i.e. two to three degrees away.
There are no free lunches.
Perhaps more important than the integrity of information itself is to ask:
What does this person stand to gain from sharing-revealing-publishing this piece of news?
Movements in the share prices of companies are very difficult to predict and understand. Many stay-at-home traders and professionals alike use technical analysis such as charts and patterns to try and explain why share prices move in a certain way. Some even claim to be able to feel the market sentiment. This ideology in itself is very complex for me. Not only is it self-fulfilling on a certain level but also potentially dangerous because it could ultimately lead you to believe that your way of thinking, your ideology is correct.
The thing is:
No one can really predict how stock prices will move. It's 50-50 every day. It's either up or down.
And those are the odds that you deal with every day.
Beyond charts, patterns and fundamental analysis, the movement in share prices are also driven by huge chunks of shares being exchanged by big institutional players such as hedge funds and asset managers. For larger companies, sometimes a dedicated team can be staffed to perform "treasury operations" which simply means buying and selling its own shares in the market - a 'loose' way for a company to control its share price in order to prevent sudden spikes.
The power of publicity.
The news and media are also very important catalysts to a company's share price. This also includes analyst coverage and recommendations on a stock. Because the information is in public, any revelation in the business will often result in significant share price movements. Perhaps the most obvious examples of these are investor activism and short seller attacks on public companies. Your DCF models, charts and expert research just aren't going to cut it if the information doesn't get picked up by the media.
At the end of the day, business valuation and trading equities are a very personal thing. Every one sitting behind the desktop sees the same information and the same world in very different ways. Their views are inevitably shaped by their backgrounds and experiences. Also, the first-hand information of one person is another person's second-hand information. Like it or not, the sentiments and confidence of both parties looking at that same piece of information, is going to be somewhat different. And as a result of that, their decisions to buy or not to buy are also based largely on their own analysis and best judgement.