Key Excerpts
Apart from fundamental, Price Volume Action matters to guesstimate the price of a business in future or near future.
People who believe in market efficient hypothesis believes you should only buying index as there is no point choosing individual stocks - basically price equal value. hence no higher return can be obtained over & above the market return.
Even in Black-Scholes model price of a derivative is dependent on value of stock which is assumed same as the price of the stock - hence a stock is undervalued or overvalued is of no relevance even to Black-Scholes valuation model.
Even accountant somewhere believes "bhav bhagwan che" - take for example Mark to Market system where investments are valued on balance sheet at the current price. Even mutual funds are valued on the basis of Current NAV (Net Asset Value).
So why people identifies price with Value?
As Price is easy to obtain, it's objective, requires no assumption and we can tell market knows everything and if you go wrong you cant sue the market 😀
Although valuations is difficult to do but "it's better to be approximately right than precisely wrong"
Benjamin Graham - Your business has a partner named Mr. Market, but he is a moody guy sometimes very crazily happy and sometime very crazily sad. In happy days he is ready to buy your share at absurdly high valuation and on sad days he want to go out and sell his stake at ridiculously low valuations. Benjamin Graham says you take advantage of your partner Mr. Market when he is so moody, sell to him when he is too happy and buy from him when is too sad. Now catch is his mood is rare majority of the time he is just normal - ignore him on normal times.
Even graham used to track stock prices, he he used to see prices and not just intrinsic value. his famous value traps ideology will help here - Graham used to have a thumb rule while buying statistically cheap stocks he used to wait for 3 years for stock to rise to his value and in 3 years if the stock would not rise sufficiently he would just exit, he used to think may be market is price. SO even for Graham at some time "Bhav was Bhagwan"
Again as per Graham Interest coverage ratio (higher the better) and Enterprise/Debt ratio should provide same answer. Higher interest coverage should also lead to higher EV/Debt and vice versa. As interest coverage ratio = EBIT / interest and EV/Debt is basically derived from interest coverage ratio only as EV = EBIT * some multiple to EBIT and Debt = Interest *(100/interest rate)
Graham used to look for situation where interest coverage ratio and EV/Debt are going in different directions. When interest coverage is high and EV/debt is low - one ratio is telling company is secure whereas one ratio (EV/Debt) is portraying companies credit worthiness is low.
There can be only three reason for the same: Books are cooked hence market is giving lower EV OR as per future fundamental market is thinking future is bleak/earnings will collapse in future and hence giving lower value today hence lower EV (EV/Debt is a futuristic ratio whereas interest coverage ratio is historic ratio) OR stock market can be wrong. In essence even he looked at stock prices he did not ignore it on the name of "Intrinsic Value".
Again a great example is Credit rating company downgrading credit rating of stocks after tremendous decline in stock values. It may be due to Credit rating companies only meets management and decide ratings and real problem comes out after decline in business prices - but whatever may be the case even they react on market prices.
One of his books he recommend is Accounting for Value by Stephen Pennman. (Read our summary of the book here)
In Accounting for value he suggest the author suggest don't account price in your picture when you are valuing the business. An example where analyst commits this mistake is lets say while valuing holding companies.
Sanjay sir quotes an example of Satyam - so Satyam has stake in a company called Sify which was listed in NASDAQ at the time of DOT COM bubble. So analyst were Valuing Satyam = Value of Satyam + market Cap/Price of Sify * Stake held by Satyam - in a nutshell the analyst where assuming the price of Sify as the value of sify (even though at that time it was quoting at 200 P/E).
Same mistakes happen when an analyst does Peer group valuation - He gives an example of a report which suggested to buy satyam because it was at a P/E was 200 and Wipro was at 400 P/E so basically the analyst was suggesting price of Wipro (multiple) = value of Satyam (multiple) 😀
How Much attention should management of the company should pay to the stock prices?
Both types of management are not correct - who does not look at stock prices ever and who are constantly glued to their stock prices. It's sometime important for management to look at the reaction of the stock market to certain corporate announcement - For example a management announces a diversification plan and size of the capex is huge the market may not like and react negatively - under such scenarios it pays a lot to look at how market is evaluating the corporate decisions.
If the price of the business goes extremely high as compared to value of the business (as per the management) actually management should go out and raise some cash by diluting equity and actually use the cash to improve the quality of the business and increase their valuations. In lending businesses this is extremely powerful point - its makes sense to dilute at high valuations as it leads to cheaper capital (inverse of P/E is E/P earnings yield) - basically market is willing to accept lower returns while giving you capital. Management should be opportunistic here - They should raise capital is they can raise cheaply - growth can come from this money. In fact the same management can be used to buyback the stock if stock falls in a short time frame enhancing the value of shareholders.
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