Why a Stock’s Price Won’t Always Reflect Its Company’s Value

What the market thinks a stock is worth right now is not the same as its intrinsic value. There are many factors and metrics to take in account that the market can overlook or inflate. In this episode of “The Morning Show” on Motley Fool Live, recorded on Dec. 21, Motley Fool analysts Sanmeet Deo and John Rotonti discuss how and why the real values of companies can change from moment to moment — and what you should do about it.

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Sanmeet Deo: I think that’s where people misstep is just looking at stock prices and thinking that’s the value of the business. That’s what the market thinks the value of business is. Is the market usually right? Could be, but over the long run. But it tends to overshoot and overexaggerate moves on the up and the downside. Instead of anchoring to old prices of what you owned it for, what the stock was, that’s the trick of valuation is, not anchoring but pinpointing of value of the stock at the time based on what it’s going to do five, 10 years from now. Like that stock you said is 70, maybe it was really worth 50 when you did your valuation, and then it dropped to 20. But then you do another valuation, you think, you know what? I think the value is 70 again because they’ve grown revenues, their margins are improving, they’ve expanded their markets, there’s more optionality, let’s say — whatever fundamental things happening with the company. Now I think it’s worth 70. Would I want to buy it if it’s at 20? If I think it’s 70, probably, because there’s that valuation discount or that gap that I think based on my valuation, not based on the price per se, but based on 70 of … it could be complicated DCF model. It could just be a multiple on earnings or cash flows that you just reasonably assumed. That is the price that you might want to buy it at. Are you going to be wrong? Possibly. Are you going to be right? Possibly. That’s the beauty of investing. You don’t know, but you just have to take the chance then and and then refine your valuation process over time and in keep iterating and say, what am I learning from this and getting closer and closer to being able to find the real value for businesses.

John Rotonti: Absolutely. Just think about businesses in a business model transition, or businesses that add an entirely new line of higher-margin revenue. Example you could have multiple people, thousands, millions of investors valued Amazon when it was an e-commerce company. They came up with some value. Then, Amazon made a little, tiny announcement that they were going to start selling cloud services. They created a brand new business line that had the TAM of cloud. Infrastructure cloud is not as large as global retail, but it is massive in and of itself. Global retail, I think the TAM is like 3 trillion, maybe more, and global cloud, I think the TAM is like a trillion. But we’re talking trillions. Amazon makes this tiny, little announcement that it’s going to create a new line of business that has a huge TAM and potentially higher margins. By the way, requires no carrying of inventory of any kind or anything like that. You had one value and then they make this announcement, you’re going to have a much different value several years later. Values change, Fools. Intrinsic values are not static. For great businesses, they tend to grow over time. Stock prices are going to grow. Anchoring on a past stock price makes less than zero sense. We all do it, but it makes less than zero sense.

Deo: Even the great investors do it. I’m sure Warren Buffett does it. He has been able to control it over time and focus on the right thing. There’s different ways you can value. Intrinsic valuation via DCF, relative valuation via multiples of what the company is doing versus other companies in its industry. There’s a private market value or what you think equity buyer, private strategic buyer might buy the business for. You can look at past acquisitions and find maybe three different values and then you may be surprised. You might come up with almost the same value or you might come with a wide range. That’s the other thing is a valuation isn’t a number. It’s not 70 dollars and 25 cents. It could be 50 to 75. That’s your target rage. Then how confident are you of it being on the lower end or on the higher end or in the middle? It’s an art form. Definitely people who are in this business for 30, 40-plus years and still challenging. One thing I want to know, too, is we’re in an unprecedented time of pandemic, pre-pandemic, post-pandemic, and then now — I don’t even what to call it right now, but hopefully declining pandemic to endemic or whatever we want to call it. But over this two-year time frame, a lot of businesses have had some extreme volatility in business. Stock price, too, but in businesses, like their revenue shut off. Their cash flow shut off. Their businesses exploded in a good way, exploded better. Are they going to be to sustain that? Probably not, because those are in unprecedented times of a whole different world environment. But will they lose all of those pandemic gains? Probably not, either. There’s a shift in thinking of things like at-home fitness or video calls, or electronic signatures, all these things. There’s kind of been a boom and bust, and as uncomfortable it is holding some of these stocks that have gone up and down. I have many stocks in my portfolio that I’ve ridden up and down. [laughs] There’s many right now. Do I think their businesses are going to go back to pre-pandemic and just give it all back? No. Will it be what it was in 2020, business-wise? No. But although it might be a middle point and with that middle point, I have to tell myself, do I feel comfortable at this steady state or slower increase of growth? Do I still feel comfortable owning a business or do I want to buy more of the business? It’s actually what makes our jobs fun — and trying. [laughs]

John Mackey, CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool’s board of directors. John Rotonti has no position in any of the stocks mentioned. Sanmeet Deo owns Amazon. The Motley Fool owns and recommends Amazon. The Motley Fool recommends the following options: long January 2022 $1,920 calls on Amazon and short January 2022 $1,940 calls on Amazon. The Motley Fool has a disclosure policy.

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