The Theory of Value Relativity

There’s an old stock market joke. Every time one person sells, another buys, and they both think they’re smart.

Value is relative. And yet. Anybody in the IR chair pencils valuations for his or her shares. Isn’t this the battle – measuring value? Karen and I on a recent trip sat with a sharp IR pro who explained how the team had an internal valuation model for company stock.

Many consider historical price-to-earnings ratios of the S&P 500 (about 16 over 130 years but ranging from below 9 in 1933 and 1983, to 40-plus in 2000, the record). Some like the S&P earnings yield versus 10-year Treasurys (7% to 2%). On that basis, markets would seem to be a whopping good buy.

And yet the Dow was down 500 points in five days through Tuesday.

There are three immutable valuation meters. You’ve got future value of cash flows. For instance, somebody at Facebook determined that Instagram’s future cash flows discounted to present value are worth $1 billion rather than the current figure of zero.

There’s net worth. When Microsoft bought AOL patents this week for $1 billion, the market added the cash to AOL’s net worth and shares shot up about 20%.

And third, there are comparables. In a residential neighborhood, you can’t do a sum-of-parts calculation. You can’t run discounted cash flow analysis, really. Instead, you compare it to other similar things. In 2006, my house on a golf course in northern California was valued at $800,000 on a comparables basis. Today the same house owned by somebody else has a Zillow estimate of $430,000.

Whew. And yet. That’s a lot higher than prices in 1999.

Back to markets. Do we think the present value of discounted future cash flows of the 30 components of the Dow Jones Industrial Average has plunged 4% the last five days? Possible but doubtful. It’s also implausible that net worth for these companies has taken a five-day drubbing.

Then it’s comparables. To what are stocks being compared that they have lost at least temporary luster? The economy? Our excellent data assessments beneath the skin of markets show money moving Mar 28-30, before moods on jobs turned sour.

So what changed? In a word, money. The specter of currency wars, quiet since December and fostering a placid surface on equities, is roiling again. If the value of money suddenly becomes suspect or relative, so do values of things denominated by them, and the first to be affected are securities sought by the nimblest money. Stocks. Derivatives. Bonds. Commodities.

Yet over and over we hear it still: It’s some holder dumping shares. That could be a reaction, but it’s not the reason.

Can’t it be rumors and investors? Sure, about 12% of the time. The other 88%, relative value – comparables – is machinating your shares, sometimes minute-by-minute.

How can we know? Because currencies are valued relatively. They have no net worth. I think much of the world is caught up in valuing things with incorrect metrics today (that’s another story).

IR folks, try to move beyond the old model of supposing something fundamental is driving every price move. And why would that be in your best interest anyway?

Wouldn’t it be better, more statistical and measurable, to size up what behaviors are moving your price, separating the stuff that behaves according to multiples of cash from the rest reacting to relative value, and report on that daily, or weekly, or monthly or quarterly – or all the above – to management?

A shot at what’s ahead: Overall sentiment is surprisingly good in money behind client shares. Stocks may recover quickly. But looking ahead, the DXY dollar index shows the same fissures it had last summer when the Euro nearly came undone. This currency crisis is coming back in weeks or months, we think.