The beginning of the next phase.

With the massive amount of liquidity in the world financial system, or as Dr. John Rutledge calls it "a tsunami of money", we should all be frightened of the prospect of the end of the contraction in aggregate demand for assets. Any increase at all in business activity will trigger an acceleration in the demand for assets and a decrease in the willingness to hold cash balances. The immediate and obvious effect will be a dizzying rise in interest rates. The only exception may be in the tax exempt bond market as the prospect of actually earning taxable business income touches off a rush to minimize taxable investment income sources.

All this implies a sectoral shift in stock preferences: higher expected equity costs of capital, driven by higher inflation fears will smother prices among high return, high growth stocks. Those commodity companies, oil, copper, and others, that have generally low returns on capital will outperform - their revenue increases will come from both volume and price and more than offset increases in equity costs of capital.

Now this change will produce lots more volatility but may only last a few quarters. However, the folks talking about "green shoots" may have much more to worry about than farming.

Now we're all well again, hmm?

The dramatic return from the walking dead of mid-March has been marked by extraordinary price gains in financial stocks. The only analysis that could've provided advance notice for the rally was the knee-deep pessimism among investors. The re-ordering of the US economy by the new administration has yet to play out, but investors are simply glad they haven't yet gone broke. The US economy is resilient, at least it has been so in past recessions. Even without immediate stimulus by government, downturns have slowed and reversed in time. Employment is usually a lagging indicator and the stock market is a leading indicator. However, the prospect of higher taxes on businesses' foreign operations, energy/carbon taxes on consumers and a crippling of the health care business does not encourage optimism. Cash flows for companies are damaged but will recover if no further burdens are imposed. We don't yet know the details, but we do know that piling on new taxes is the wrong way to get growth going again.

How much does Intrinsic Value count when prices are at extreme lows?

The problem with disrupted markets is one of credibility. When fear grips investors and when sales are plunging is the long run relevant. The fundamental characteristic of common stocks is ownership of a piece of the actual business - for the lifetime of the company! Sales growth and profit are the metrics that give stocks intrinsic value. Prices heading toward zero limits the time horizon investors are willing to consider in valuing a company's business.

When markets are in this panic mode, the balance sheet becomes the primary focus. When debt comes due and payable in a bear market such as this one, survival is at risk. Many of the most leveraged firms have scrambled to refinance and extend maturities of their debt loads and thus build confidence that their debt is manageable. Companies that have an aura of sustainability can be good long term investments. The tools for estimating intrinsic value can be used by investors to estimate future returns from owning these companies' shares.

But using models to value companies where sustainability is highly suspect makes no sense whatever. And speculating about which of these "walking dead" companies might survive is worse than gambling: you can't even judge the odds!

The Theory of Present Value

The foundations of valuation arise from a simple concept. Investors buy securities to increase their wealth, not to go broke. If the securities of a company do not represent an ability to generate cash flows now and in the future, the price of those securities will ultimately decline. Estimating that cash-generating capacity is the task of the equity analyst.

The tools that have been developed to deal with this task usually take the form of some type of spreadsheet and formulas that combine both the timing and magnitude of cash flows in some periodic accumulation, either quarterly or annual periods, stretching out into the misty future.

How to estimate these cash flows and the formulas that are used to translate those flows into an intrinsic value in the present moment are the challenges for analysts and investors.

The mission of this blog is to explore the problems and opportunities involved in valuation analysis.