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The principle that financial markets accurately reflect the underlying value of traded stocks has been widely accepted in the investment world since the 1960s. It is predicated on the assumption that investors make buy or sell decisions based on a rational view of a company’s future cash flow: that is, they consider all the relevant information, and markets allocate capital to companies efficiently.
How stocks are valued is critically important to corporate managers. If the promise of future cash flow is what attracts investors, then it makes sense for managers to pursue strategic moves that generate the most cash. And it follows that a manager will evaluate different investment options by comparing their discounted cash flows.
Recently, however, the rational view has been under attack from adherents of behavioral finance. “Behaviorists” suggest that irrational investor decisions on the part of many can strongly influence the market value of companies. Since the publication of Werner DeBondt and Richard Thaler’s 1985 Journal of Finance article “Does the Stock Market Overreact?” a number of finance academics and practitioners have jumped into the fray, arguing that stock markets do not reflect economic fundamentals as well as people think. More specifically, they maintain, there are instances when stock market valuations can and do make significant and lasting deviations from the companies’ intrinsic value.
For managers who have been taught that there are proven and incontrovertible methods for weighing strategic options — and that picking the best option would sooner or later have a positive effect on the value of the company — the behaviorist critique is unsettling, to say the least. Does this mean that managers should stop relying on DCF to make choices? In a word, no.
According to our analysis, significant discrepancies between market value and intrinsic value are rare. What’s more, markets and individual share prices that are out of sync with economic fundamentals usually come back into proper alignment relatively quickly. This happened during the late 1970s, when inflation-conscious investors pushed stock valuations too low. Even during the “bubble” of the late 1990s, it was only a small subset of stocks in telecommunications, media and high tech (with large market capitalizations and extremely high price-earnings ratios) that sent the market soaring. Although the average S&P 500 price-earnings ratio in 1999 was about 30, most of the companies in the index were trading at 22 times earnings or lower.
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