Are stock prices predictive of future profitability of a company?
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Are stock prices predictive of future profitability of a company?
Stock prices are forward looking.
Stock prices are present values of future cash flows.
A change in price at a given time must be a revision of the future cash flow OR the discount factor that converts the future cash flow to the present value OR both.
But, in the end, we should be able to tell whether this way of thinking about stock prices is correct.
Take for example IBM.
It started trading in 1911. We have over 100 years of data about IBM's cash flow and stock price. From this, we can back out the discount rate.
From this we can answer two questions.
1/ was the market expectation of the future cash flow in line with the actual cash flow IBM reported over the years?
2/ was the discount rate within a range of expectations to justify the observed stock prices throughout it's history?
What do you all think?
Stock prices are present values of future cash flows.
A change in price at a given time must be a revision of the future cash flow OR the discount factor that converts the future cash flow to the present value OR both.
But, in the end, we should be able to tell whether this way of thinking about stock prices is correct.
Take for example IBM.
It started trading in 1911. We have over 100 years of data about IBM's cash flow and stock price. From this, we can back out the discount rate.
From this we can answer two questions.
1/ was the market expectation of the future cash flow in line with the actual cash flow IBM reported over the years?
2/ was the discount rate within a range of expectations to justify the observed stock prices throughout it's history?
What do you all think?
Last edited by lomiras285 on Sat May 21, 2022 3:00 pm, edited 2 times in total.
Re: Are stock prices predictive of future profitability of a company?
Stock prices are present values of future cash flows.
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Re: Are stock prices predictive of future profitability of a company?
Do you mean conceptually, in general? --> Yes, stocks (or the pricing of assets) is supposed to reflect their cash flow / return stream (stocks have a higher degree of uncertainty; everything is an estimate).
But obviously not perfectly all of the time - look at the micro-bubbles bursting right now (Peleton, Carvana, even Netflix to some degree, etc.). And you mentioned discounting: Discount rates (generally US-interest rates) can change, both in nominal and in real terms. There are a lot of moving parts.
Stocks are volatile as traders (buyers and sellers) estimate what the value of the company prospects are, at any given time, under various economic circumstances, or are forced to buy or sell for other-than economic reasons (e.g., margin call / collateral liquidation).
IBM has been very highly valued at times; now, I believe not so much (disappointing revenue growth [even declines] the last several years). No one knows the future, but thankfully enough active participants try, to give us indexers a free lunch, of sorts
(I realize not all markets, even equity markets, are equally efficient and work super well for index investing. Large-cap US stocks are probably the best for index funds.)
But obviously not perfectly all of the time - look at the micro-bubbles bursting right now (Peleton, Carvana, even Netflix to some degree, etc.). And you mentioned discounting: Discount rates (generally US-interest rates) can change, both in nominal and in real terms. There are a lot of moving parts.
Stocks are volatile as traders (buyers and sellers) estimate what the value of the company prospects are, at any given time, under various economic circumstances, or are forced to buy or sell for other-than economic reasons (e.g., margin call / collateral liquidation).
IBM has been very highly valued at times; now, I believe not so much (disappointing revenue growth [even declines] the last several years). No one knows the future, but thankfully enough active participants try, to give us indexers a free lunch, of sorts
(I realize not all markets, even equity markets, are equally efficient and work super well for index investing. Large-cap US stocks are probably the best for index funds.)
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Re: Are stock prices predictive of future profitability of a company?
It must be or the price would just jump around like crazy nonsense. Instead, the price at each moment is usually pretty close to the preceding price. So it is predictive of its own future value.
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Re: Are stock prices predictive of future profitability of a company?
So weird...I had been noodling on this EXACT question the last few days myself but haven't sat down to work through the details. I'll be interested to see the direction this thread takes.lomiras285 wrote: ↑Sat May 21, 2022 2:40 pm Stock prices are forward looking.
Stock prices are present values of future cash flows.
A change in price at a given time must be a revision of the future cash flow OR the discount factor that converts the future cash flow to the present value OR both.
But, in the end, we should be able to tell whether this way of thinking about stock prices is correct.
Take for example IBM.
It started trading in 1911. We have over 100 years of data about IBM's cash flow and stock price. From this, we can back out the discount rate.
From this we can answer two questions.
1/ was the market expectation of the future cash flow in line with the actual cash flow IBM reported over the years?
2/ was the discount rate within a range of expectations to justify the observed stock prices throughout it's history?
What do you all think?
Re: Are stock prices predictive of future profitability of a company?
Some portfolio theories might suggest you can't look at a single stock to work this out, especially picking one in hindsight with the benefit of survivorship bias. You'd need to look at a portfolio of multiple stocks, or perhaps the whole market... but whatever discount rate is used, we already know that diversified stocks / "the market" beat bonds, and even using theorized equity risk premium models, stocks beat bonds on a "risk adjusted" basis (hence the Equity Premium Puzzle.)
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Re: Are stock prices predictive of future profitability of a company?
I meant it in a sarcastic mocking way. It's an emoji sequence popularized during the "meme stock" run up where people on sites like reddit "Wall Street Bets" attempted a short-squeeze on some stocks of companies in failing businesses that they believed had too many shares sold short, and by buying them up and holding on they could force the short-sellers (who have to eventually buy the shares to cover) to buy at high "too the moon!" prices.
The market price of some of these stocks did go way up, way beyond any rational explanation based on the businesses expected cash flows, so I was using it (partly) in jest mocking the idea that stocks are valued that way.
The emoji's can be read as "Apes Together Strong" (stock chart going up) "Diamond Hands" implying if the people who bought the stocks just hold on the price will just keep going up.
Members of reddits "Wall Street Bets" community will frequently refer to each other as "Apes", and the line "Apes Together Strong" is a quote from the 2011 movie "Rise of the Planet of the Apes"
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Re: Are stock prices predictive of future profitability of a company?
Can you please write a little more in detail, with BH audience in mind, about how the equity risk premium relates to the original post about checking if the cash flow, discount rate and price are dancing in tango? Thanks!JoMoney wrote: ↑Sat May 21, 2022 3:29 pm Some portfolio theories might suggest you can't look at a single stock to work this out, especially picking one in hindsight with the benefit of survivorship bias. You'd need to look at a portfolio of multiple stocks, or perhaps the whole market... but whatever discount rate is used, we already know that diversified stocks / "the market" beat bonds, and even using theorized equity risk premium models, stocks beat bonds on a "risk adjusted" basis (hence the Equity Premium Puzzle.)
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Re: Are stock prices predictive of future profitability of a company?
A coincidenceincognito_man wrote: ↑Sat May 21, 2022 3:15 pmSo weird...I had been noodling on this EXACT question the last few days myself but haven't sat down to work through the details. I'll be interested to see the direction this thread takes.lomiras285 wrote: ↑Sat May 21, 2022 2:40 pm Stock prices are forward looking.
Stock prices are present values of future cash flows.
A change in price at a given time must be a revision of the future cash flow OR the discount factor that converts the future cash flow to the present value OR both.
But, in the end, we should be able to tell whether this way of thinking about stock prices is correct.
Take for example IBM.
It started trading in 1911. We have over 100 years of data about IBM's cash flow and stock price. From this, we can back out the discount rate.
From this we can answer two questions.
1/ was the market expectation of the future cash flow in line with the actual cash flow IBM reported over the years?
2/ was the discount rate within a range of expectations to justify the observed stock prices throughout it's history?
What do you all think?
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Re: Are stock prices predictive of future profitability of a company?
Pets.com was priced at a gazillion dollars in the dot.com era. Never made a penny of profit.
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Re: Are stock prices predictive of future profitability of a company?
Sure it was priced that way; there is no such thing as “a gazillion dollars”. Hence, it is gone forevermore having a non-real market value.CraigTester wrote: ↑Sat May 21, 2022 10:01 pm Pets.com was priced at a gazillion dollars in the dot.com era. Never made a penny of profit.
Passive investing: not about making big bucks but making profits. Active investing: not about beating the market but meeting goals. Speculation: not about timing the market but taking profitable risks.
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Re: Are stock prices predictive of future profitability of a company?
Why wouldn't it be correct?lomiras285 wrote: ↑Sat May 21, 2022 2:40 pm Stock prices are forward looking.
Stock prices are present values of future cash flows.
A change in price at a given time must be a revision of the future cash flow OR the discount factor that converts the future cash flow to the present value OR both.
But, in the end, we should be able to tell whether this way of thinking about stock prices is correct.
Estimating the cash flows far in the future is very difficult, highly uncertain and plays a big role in determining the fair value of the stock. So, individual stocks are highly volatile, as we know.
Discount factor (risk premium) also depends on the constantly changing market conditions (and future projections of those market conditions) and many other things, and can also have a big impact on the fair market value of the stock.
So the thinking is fine in theory, but extremely difficult to implement precisely in practice.
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Re: Are stock prices predictive of future profitability of a company?
I am not saying it is not correct. Rather this way of thinking could be verified using companies that survived for a long period of time. Someone mentioned above that it introduces survivorship bias. This is correct. We cannot use this as a verification. But we can use it as a falsification.ivgrivchuck wrote: ↑Sun May 22, 2022 2:31 amWhy wouldn't it be correct?lomiras285 wrote: ↑Sat May 21, 2022 2:40 pm Stock prices are forward looking.
Stock prices are present values of future cash flows.
A change in price at a given time must be a revision of the future cash flow OR the discount factor that converts the future cash flow to the present value OR both.
But, in the end, we should be able to tell whether this way of thinking about stock prices is correct.
Estimating the cash flows far in the future is very difficult, highly uncertain and plays a big role in determining the fair value of the stock. So, individual stocks are highly volatile, as we know.
Discount factor (risk premium) also depends on the constantly changing market conditions (and future projections of those market conditions) and many other things, and can also have a big impact on the fair market value of the stock.
So the thinking is fine in theory, but extremely difficult to implement precisely in practice.
Re: Are stock prices predictive of future profitability of a company?
Stock price represents the current supply and demand of the stock, nothing more and nothing less.
To believe stock price represents the discounted value of future cash flow, you’ll have to believe a lot of theories and that market participants are mostly rational.
To believe stock price represents the discounted value of future cash flow, you’ll have to believe a lot of theories and that market participants are mostly rational.
The sillier the market’s behavior, the greater the opportunity for the business like investor.
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Re: Are stock prices predictive of future profitability of a company?
or is it the Baader-Meinhof Phenomenon?lomiras285 wrote: ↑Sat May 21, 2022 6:44 pmA coincidenceincognito_man wrote: ↑Sat May 21, 2022 3:15 pmSo weird...I had been noodling on this EXACT question the last few days myself but haven't sat down to work through the details. I'll be interested to see the direction this thread takes.lomiras285 wrote: ↑Sat May 21, 2022 2:40 pm Stock prices are forward looking.
Stock prices are present values of future cash flows.
A change in price at a given time must be a revision of the future cash flow OR the discount factor that converts the future cash flow to the present value OR both.
But, in the end, we should be able to tell whether this way of thinking about stock prices is correct.
Take for example IBM.
It started trading in 1911. We have over 100 years of data about IBM's cash flow and stock price. From this, we can back out the discount rate.
From this we can answer two questions.
1/ was the market expectation of the future cash flow in line with the actual cash flow IBM reported over the years?
2/ was the discount rate within a range of expectations to justify the observed stock prices throughout it's history?
What do you all think?
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Re: Are stock prices predictive of future profitability of a company?
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Re: Are stock prices predictive of future profitability of a company?
They are predictive of predicted future profitability, I suspect.
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Re: Are stock prices predictive of future profitability of a company?
I think my question in my mind is slightly different. I was asking myself the following:
(1) Look back 30yrs from today
(2) Assume the market is efficient and every stock's P/E ratio at that time is the "correct" P/E ratio for all known information at that time.
(3) Propagate that P/E ratio forward 30 years for every company with the understanding that any changes to the actual P/E were due to unpredictable events in those 30 years.
(4) Factoring in dividends, and using the same P/E from 30 years ago, calculate the hypothetical return of each company.
(4) Using the current-day earnings + dividends, back-calculate what the price SHOULD have been 30 years ago.
(5) Compare
(1) Look back 30yrs from today
(2) Assume the market is efficient and every stock's P/E ratio at that time is the "correct" P/E ratio for all known information at that time.
(3) Propagate that P/E ratio forward 30 years for every company with the understanding that any changes to the actual P/E were due to unpredictable events in those 30 years.
(4) Factoring in dividends, and using the same P/E from 30 years ago, calculate the hypothetical return of each company.
(4) Using the current-day earnings + dividends, back-calculate what the price SHOULD have been 30 years ago.
(5) Compare
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Re: Are stock prices predictive of future profitability of a company?
At a specific point of time, each company has hundreds/thousands different kind of potential futures ahead of it. Market valuations are a weighted average of those futures. One of those futures becomes reality, if it was more positive than the average, stock price goes up, if it was more negative than average, stock price goes down.lomiras285 wrote: ↑Sun May 22, 2022 10:06 amI am not saying it is not correct. Rather this way of thinking could be verified using companies that survived for a long period of time. Someone mentioned above that it introduces survivorship bias. This is correct. We cannot use this as a verification. But we can use it as a falsification.ivgrivchuck wrote: ↑Sun May 22, 2022 2:31 amWhy wouldn't it be correct?lomiras285 wrote: ↑Sat May 21, 2022 2:40 pm Stock prices are forward looking.
Stock prices are present values of future cash flows.
A change in price at a given time must be a revision of the future cash flow OR the discount factor that converts the future cash flow to the present value OR both.
But, in the end, we should be able to tell whether this way of thinking about stock prices is correct.
Estimating the cash flows far in the future is very difficult, highly uncertain and plays a big role in determining the fair value of the stock. So, individual stocks are highly volatile, as we know.
Discount factor (risk premium) also depends on the constantly changing market conditions (and future projections of those market conditions) and many other things, and can also have a big impact on the fair market value of the stock.
So the thinking is fine in theory, but extremely difficult to implement precisely in practice.
If you examine a large number of companies in the past data, you'll find ones that did better than expected, you'll find ones that did worse than expected. You'll find time periods when market as a whole did better than expected, you'll find time periods when market as a whole did worse than expected.
I'm not sure what exactly you are proposing...
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Re: Are stock prices predictive of future profitability of a company?
Well, if they aren't rational, you can calculate the true correct value of any company and beat all the other irrational market participants in the long run by investing only in the undervalued companies.
Many have tried, few have succeeded...
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Re: Are stock prices predictive of future profitability of a company?
True but the expectation must be unbiased in that the average outcome of cash flows and discount rates over a long period of time (hence the IBM example above) must be almost equal to the expectation.ivgrivchuck wrote: ↑Sun May 22, 2022 4:05 pmAt a specific point of time, each company has hundreds/thousands different kind of potential futures ahead of it. Market valuations are a weighted average of those futures. One of those futures becomes reality, if it was more positive than the average, stock price goes up, if it was more negative than average, stock price goes down.lomiras285 wrote: ↑Sun May 22, 2022 10:06 amI am not saying it is not correct. Rather this way of thinking could be verified using companies that survived for a long period of time. Someone mentioned above that it introduces survivorship bias. This is correct. We cannot use this as a verification. But we can use it as a falsification.ivgrivchuck wrote: ↑Sun May 22, 2022 2:31 amWhy wouldn't it be correct?lomiras285 wrote: ↑Sat May 21, 2022 2:40 pm Stock prices are forward looking.
Stock prices are present values of future cash flows.
A change in price at a given time must be a revision of the future cash flow OR the discount factor that converts the future cash flow to the present value OR both.
But, in the end, we should be able to tell whether this way of thinking about stock prices is correct.
Estimating the cash flows far in the future is very difficult, highly uncertain and plays a big role in determining the fair value of the stock. So, individual stocks are highly volatile, as we know.
Discount factor (risk premium) also depends on the constantly changing market conditions (and future projections of those market conditions) and many other things, and can also have a big impact on the fair market value of the stock.
So the thinking is fine in theory, but extremely difficult to implement precisely in practice.
If you examine a large number of companies in the past data, you'll find ones that did better than expected, you'll find ones that did worse than expected. You'll find time periods when market as a whole did better than expected, you'll find time periods when market as a whole did worse than expected.
I'm not sure what exactly you are proposing...
Thus we can backtest whether the market's expectation of cash flows and discount rates, e.g. in 1911 for IBM, was in line with the observed price in 1911, using data about cash flows and discount rates from 1911 to today.
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Re: Are stock prices predictive of future profitability of a company?
Should I enroll in an ESL course at night school? (That's Emoji as a Second Language.)
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Re: Are stock prices predictive of future profitability of a company?
The future is a probabilistic event, so the correct value of a stock is a random variable. You could get some expected value or a conservative estimation. But if those don’t give you enough margin of safety, you might still lose money or underperform the market.ivgrivchuck wrote: ↑Sun May 22, 2022 4:12 pmWell, if they aren't rational, you can calculate the true correct value of any company and beat all the other irrational market participants in the long run by investing only in the undervalued companies.
Many have tried, few have succeeded...
I absolutely do not believe any of those growth stocks or meme stocks trade anywhere near their discounted future cashflow. A company that has no cashflow for the next 5+ years is simply too uncertain that nobody has any clue what its real value is. Such stocks trade on the mood of the market and the herd behavior of the crowd. If you think these people are rational…
The sillier the market’s behavior, the greater the opportunity for the business like investor.
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Re: Are stock prices predictive of future profitability of a company?
It would be foolish to think that the market is 100% rational 100% of the time. There are clear examples that this is not the case, like:gougou wrote: ↑Sun May 22, 2022 9:13 pmThe future is a probabilistic event, so the correct value of a stock is a random variable. You could get some expected value or a conservative estimation. But if those don’t give you enough margin of safety, you might still lose money or underperform the market.ivgrivchuck wrote: ↑Sun May 22, 2022 4:12 pmWell, if they aren't rational, you can calculate the true correct value of any company and beat all the other irrational market participants in the long run by investing only in the undervalued companies.
Many have tried, few have succeeded...
I absolutely do not believe any of those growth stocks or meme stocks trade anywhere near their discounted future cashflow. A company that has no cashflow for the next 5+ years is simply too uncertain that nobody has any clue what its real value is. Such stocks trade on the mood of the market and the herd behavior of the crowd. If you think these people are rational…
https://en.wikipedia.org/wiki/2010_flash_crash
But it's fair to expect that market is mostly rational most of the time. There are exceptions like meme stocks, but trying to exclude these from the total market portfolio is likely going to be more trouble than what it's worth.
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Re: Are stock prices predictive of future profitability of a company?
Is trying to catch a Momentum premium not rationale?ivgrivchuck wrote: ↑Mon May 23, 2022 2:21 amIt would be foolish to think that the market is 100% rational 100% of the time. There are clear examples that this is not the case, like:gougou wrote: ↑Sun May 22, 2022 9:13 pmThe future is a probabilistic event, so the correct value of a stock is a random variable. You could get some expected value or a conservative estimation. But if those don’t give you enough margin of safety, you might still lose money or underperform the market.ivgrivchuck wrote: ↑Sun May 22, 2022 4:12 pmWell, if they aren't rational, you can calculate the true correct value of any company and beat all the other irrational market participants in the long run by investing only in the undervalued companies.
Many have tried, few have succeeded...
I absolutely do not believe any of those growth stocks or meme stocks trade anywhere near their discounted future cashflow. A company that has no cashflow for the next 5+ years is simply too uncertain that nobody has any clue what its real value is. Such stocks trade on the mood of the market and the herd behavior of the crowd. If you think these people are rational…
https://en.wikipedia.org/wiki/2010_flash_crash
But it's fair to expect that market is mostly rational most of the time. There are exceptions like meme stocks, but trying to exclude these from the total market portfolio is likely going to be more trouble than what it's worth.
It seems obvious that meme stocks are an attempt to do so.
Catching momentum is difficult I think.
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Re: Are stock prices predictive of future profitability of a company?
There are small market inefficiencies here and there, that a rational investor can try to capture.typical.investor wrote: ↑Mon May 23, 2022 6:20 am Is trying to catch a Momentum premium not rationale?
It seems obvious that meme stocks are an attempt to do so.
Catching momentum is difficult I think.
- Meme stocks can be shorted, but there is a risk that irrational behavior can continue for a long time
- One can try to capture momentum premium, by buying and selling stocks at the right time. However while momentum premium has existed in the past, there is no guarantee that it continues to exist in the future (it may be likely, but not guaranteed), and one can incur significant spread costs. So it is no panacea.
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Re: Are stock prices predictive of future profitability of a company?
Nobody has any clue how much the meme stocks and growth stocks will be worth. They have no cash flow and they don’t trade on fundamentals. The aggregate trading game on such stocks are a negative sum game for most people, where only the brokerage, market-maker and maybe some quant trading firms making consistent profit. No one cares about the intrinsic value of the company, so the stock prices of meme stocks and most growth stocks definitely do not reflect the future profitability/cashflow of the companies.typical.investor wrote: ↑Mon May 23, 2022 6:20 amIs trying to catch a Momentum premium not rationale?ivgrivchuck wrote: ↑Mon May 23, 2022 2:21 amIt would be foolish to think that the market is 100% rational 100% of the time. There are clear examples that this is not the case, like:gougou wrote: ↑Sun May 22, 2022 9:13 pmThe future is a probabilistic event, so the correct value of a stock is a random variable. You could get some expected value or a conservative estimation. But if those don’t give you enough margin of safety, you might still lose money or underperform the market.ivgrivchuck wrote: ↑Sun May 22, 2022 4:12 pmWell, if they aren't rational, you can calculate the true correct value of any company and beat all the other irrational market participants in the long run by investing only in the undervalued companies.
Many have tried, few have succeeded...
I absolutely do not believe any of those growth stocks or meme stocks trade anywhere near their discounted future cashflow. A company that has no cashflow for the next 5+ years is simply too uncertain that nobody has any clue what its real value is. Such stocks trade on the mood of the market and the herd behavior of the crowd. If you think these people are rational…
https://en.wikipedia.org/wiki/2010_flash_crash
But it's fair to expect that market is mostly rational most of the time. There are exceptions like meme stocks, but trying to exclude these from the total market portfolio is likely going to be more trouble than what it's worth.
It seems obvious that meme stocks are an attempt to do so.
Catching momentum is difficult I think.
The sillier the market’s behavior, the greater the opportunity for the business like investor.