Why stock prices move (Part 2 – The Long Term)

At a glance

  • An investor needs to remember that a stock price represents ownership in an underlying business
  • Therefore, a “fair value” for a stock depends on the market’s projection of future business performance
  • Wearing an optimistic or a pessimistic lens can provide large ranges for this “fair value”
  • The opportunity for the calm investor is in not getting caught up in the overly optimistic or the pessimistic views and comparing a prevailing stock price with what would be a realistic price based on historical business performance

“In
The Intelligent Investor the short run, the market is a voting machine but in the long run it is a weighing machine” -Benjamin Graham (author of ‘Security Analysis’ & ‘The Intelligent Investor’)

Stock Price as a barometer of Business Performance – A simple case study

Here’s a short and simple exercise. Think of a successful small business in your neighbourhood. I can think of a barber shop ‘Altaf Scissorhands’ that seems to do good business no matter which day of the week. If the owner of this shop, Altaf, came up to me and offered me one share or 0.01% of his business, I’d have to consider a few things before deciding on a price I’d be willing to pay.

First, a few specifics of the business:

Revenue

  • 5 stations manned by 5 barbers paid monthly
  • Works 6 days a week including the weekend
  • On weekdays he has 25-odd customers, weekends over 55
  • Each customers pays on average ₹150

Cost

  • He rents the real estate and pays ₹150 / sq foot for a 150 Sq foot store
  • Pays each of his five employees ₹10,000 / month
  • Utilities and other costs come to ₹12,000 / month

Key considerations

8 key considerations

  • Some quick back of the envelope calculations indicate monthly revenue of ₹1.42 Lakh and cost of ₹0.8L which leave ₹4.8L annually after tax. At the end of the 1st year, I’d therefore be eligible to receive ₹48 (0.01% of ₹4.8L)
  • Since the shop’s been around for a while and managed to hold its own against competition, its lease is long-term and its employees loyal, I have good reason to believe this situation is sustainable for the next 7 years. This means ₹48 a year for the next seven years

Initial Projection

8 Initial Projection

Imagine my only other avenue of investment is fixed deposits giving me 10% returns which is the rate by which I’ll need to discount the future annual payments of ₹48 (rounded), I stand to receive to arrive at the price of ₹234. Note that at this price, I’d be indifferent between putting my money into alternate investment avenues and buying that 1 share of the barbershop. But what if other potential investors looked at thing differently?

Optimistic Investor

The optimistic investor assumes Altaf is an excellent manager and keeps looking for ways to improve his business. He thinks, Altaf keeps a spotless store, offers comfortable seating for waiting customers and friendly service, he will be able to increase the daily customer walk-ins on weekdays from 25 to 35.

8 Good Management

The resulting impact to annual earnings is significant, from ₹4.8L to ₹7L and the resulting change to the share’s value is to go from ₹234 to ₹345, a 47% increase that came purely from improvement in the business operations!

Pessimistic Investor

Conversely, the pessimistic investor assumes the worst about the business. He believes so for reasons like attrition of the best employees, increasing competition and real estate costs, to stay competitive, Altaf will need to reduce prices so that there’s a 17% drop in the average revenue / customer from ₹150 to ₹125. The result us an annual income drop from ₹4.8L to ₹2.8L and translates to a drastic drop in the corresponding value of the share from ₹235 down to ₹138, a 40% decrease.

8 Bad Management

While this is an extremely simplistic example, it serves to illustrate the point being made by Ben Graham, how in the long run, stock prices move to reflect investor’s perceptions or projections of the performance of the underlying business. This movement doesn’t happen overnight but often takes months or years even as the various steps taken by management gradually percolate into the financial results.

The opportunity for the calm investor

But this is a hypothetical business with a share price calculated using simplistic assumptions. In the stock market, prices move not only when there are significant factors impacting the business, but also due to overblown expectations, pessimistic outlooks and often for seemingly no reason at all. The biggest case for equity investing is made by the tendency of the markets to regularly deviate from what is the “fair value” of stocks, collectively and specifically.

In the case of our favourite hair salon, it could be that a local daily publishes a survey saying people will increasingly look to grow their hair long and local analysts might translate that into a big drop in customers at Altaf’s and put a ‘Sell’ rating on the stock. Another report might speak of tattoo parlours as the best small business to invest in followed by talk of a potential new tax on hair salons in the next budget.

The Ben Graham School of investing says that the price of stocks reverts to their respective fair value over time and an understanding of these deviations provides an opportunity for the calm investor to make steady returns regularly.

3 thoughts on “Why stock prices move (Part 2 – The Long Term)

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  • April 2, 2015 at 9:45 am
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    Hi Anoop,

    I have a doubt in the way the share price calculated. In this example investment horizon is chosen as 7-year so the price came to 234 rupees.

    Now if we choose an investment period of 5-year and 10-year will it be 183 rupees and 295 rupees respectively?

  • April 6, 2015 at 11:51 am
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    Kanagu, that’s right. Increasing the time period will increase the value in this case.

    I intentionally did not consider the concept of terminal value in the calculation in this post since I wanted to illustrate the linkage between earnings and what a company could be worth while keeping things simple.

    Have a look at this post for a more formal look at stock price and earnings (https://thecalminvestor.com/decoding-the-pe-ratio-of-a-stock/)

What do you think?