Investment Concepts for Everyone!! (part 2)

It is my goal to produce a series of short articles that discuss financial concepts that I believe can be useful to non-professional investors. Everything I write here reflects my personal opinions. Nothing here should be taken as investment advice. Instead, I hope to learn, and encourage learning, by sharing my understanding and learning from your feedback. I hope this becomes more a series of conversations than anything else.

If one does not believe that the financial markets are very efficient, how might one take advantage of market inefficiencies to earn a profit? This is a humungous question. Let's begin our discussion by examining how one might value an individual company. This examination will span multiple articles, so please be patient.

First we must understand what it means to value a company. A valuation is simply a best guess estimate of the "true" value of the firm (or its stock). Please remember that this analysis is only relevant if we believe that market pricing is inefficient. If we believe that market pricing is efficient, there is no need to estimate the "true" value of the company. Market efficiency would imply that the market price reflects the "true" value.

Let's explore the valuation idea a bit further by looking at an actual company. A recently quoted price for Delta Air Lines stock (February 26th) was $47.94 per share. Is this the price that Delta should sell for or has the market mispriced the stock by failing to properly account for business and/or economic conditions? If, after some sort of analysis, we believe that Delta should sell for $55 per share, then we would consider buying the stock at $47.94 with the expectation that the price will rise (hopefully soon). If, on the other hand, we believe that Delta should sell for $40 per share, then we would not purchase the stock at the current price. How might we determine our best guess for the correct stock price?

For our first attempt at valuing Delta stock, let's begin by computing the 60 day average. Why 60 days? I chose 60 days because the prices were relatively stable over this period and I don't know of any major economic or company specific events that would have significantly impacted the price during this period. It just makes the discussion easier.

The average price for Delta stock over the last 60 trading days was $41.58. That's it, we're done! This is our first guess at the "true" value of Delta stock. (I would recommend that you try downloading the data for longer or shorter periods to see how the average changes.) If I believe that Delta stock should sell for $41.58, would I be willing to pay $47.94? Of course not!

Is using the average a good approach to valuation? After all, it's easy to understand and I can replicate this process across many stocks quickly. So, what's not to like about this approach? The approach is backward looking. This means that the valuation considers only past information. The problem here is that if we purchase Delta stock today, we hope to earn a profit in the future. Therefore, our valuation should take into account our best guesses about the economy, the industry and the company for the future. What do we believe will happen to interest rates? What will Delta's competitors do to improve their positions? Do we have confidence in the leadership of Delta's management team? Questions such as these illustrate factors that make valuations challenging. We should also notice that older stock prices carry the same weight as newer stock prices in the valuation.

Would anyone actually use the average as a valuation approach? Yes, the thinking goes something like this. Before the pandemic, Delta was selling for roughly $50.00 per share. After the pandemic hit, the share price dropped. Perhaps you noticed when the share price was in the mid $20s. The argument is then made that Delta stock is selling below its "true" value. Notice the assumption that the previous prices indicate the "true" value. One, clearly, must be careful of this reasoning because it does not account for the economic and business impacts of the pandemic.

Now, let's examine the data from a different perspective. We use the fact that the stock price data is a time series. We can plot the 60 daily prices and construct a regression line...

Now we can use the equation on the picture to get a different estimate of the price for day 61. The estimate is now $43.77. This approach has several major problems as well. First, we now need to understand the details of regression and time series analysis. MS Excel can generate the equation rather easily. The hard part comes from determining whether this model is appropriate in the first place. One must consider questions of residual analysis, auto-regression and other mathematical issues that may not be very intuitive. Second, in this example we find that only about 22.5% of the variation in the stock price can be explained by the progression of time. Clearly, there are other factors that will influence the future stock price. Third, we are still using past data to extrapolate future prices.

It turns out that neither of these approaches is ideal for firm valuation. In the next article, we will begin to discuss techniques that may give us higher quality estimates of the firm's (or stock's) value. As you will see, we will have to make several assumptions.