Fundamentally Unsound

Instead of judging the market price by established standards of value, the new era based its standards of value upon the market price. Hence, all upper limits disappeared, not only upon the price at which a stock could sell, but even upon the price at which it would deserve to sell.

– Benjamin Graham & David Dodd, Security Analysis, 1934

As in all periods of speculation, men sought not to be persuaded by the reality of things but to find excuses for escaping into the new world of fantasy.

– John Kenneth Galbraith, The Great Crash 1929, published 1954

Improvise is the keyword. There’s so much give in the basics [cash flow, growth, and risk] that I can stretch them to meet just about any requirement that I need, any conditions I face. The historical data become a crutch. The first thing we need to do is abandon the need for it. Mean-reversion works until it doesn’t. There are a lot of lazy arguments being made for stocks being overvalued because a normal P/E for the S&P is about 16. Where do you get that? Well, the Shiller data are from 1871 to 2009. Come on.

– Aswath Damodaran, Barron’s, June 2020

Valuations and long-term returns

Last week, my wife Terri was reaching for a coffee cup in the kitchen, and noticed a little piece of paper taped to the corner of the wall, near the ceiling. It read “$100.” Admittedly, it was my doing. I had accidentally left it there for weeks.

It’s an illustration I often use to explain how valuations work. Suppose that the $100 taped in the upper corner of the room will be delivered a decade from today, and you’re deciding how much to pay today for that future piece of paper.

Drop your hand toward the floor. If you pay $19 today for $100 a decade from now, you’ll earn 18% annually on your investment.

Raise your hand a little higher. If you pay $32, you’ll get 12% annually. Raise your hand above chest-level. If you pay $46, you’ll get 8%. Raise your hand to the top of your head. If you pay $67, you’ll get 4%. Now reach above your head. If you pay $82, you’ll get 2%. Jump in the air so your hand is even with the piece of paper. If you pay $100, you’ll get 0%. And if you’re aggressive enough to pay more than $100 today for that future $100 payment, you’ll get a negative return on your investment over the coming decade.

That’s the first rule of valuation. Given any set of future cash flows, the higher the price you pay today, the lower the long-term rate of return you can expect on your investment. Nothing about this relies on mean-reversion. It’s just arithmetic.