The Disconnect between Investment Theory and Practice

What’s the Problem With Investment Theory?

A disconnect between investment theory and investment practice exists and is manifested in the way investors should value stocks versus the way they actually do value stocks. New Constructs provides the tools to solve this problem.

“We still don’t know how to value companies” — Matthew Bishop, senior writer for The Economist on CNN on 5/17/02

The problem with popular valuation techniques, such as price to earnings, price to revenues, and EBITDA ratios, is twofold: they are shortcuts that fail in their attempts to supplant proper discounted cash flow analysis, and they are entirely based on reported accounting data. Too many analysts and investors rely on the face value of reported financial statements and base valuations on those numbers. Financial statements were never designed for equity investors. They were created for accountants and creditors, who have different financial priorities than equity investors. For this reason, it is not surprising that companies’ stock prices do not correlate with accounting metrics.

So What Drives Stock Market Valuation?

The value of any asset equals the discounted present value of its cash flows. See how my discounted cash flow model works.

As far back as the 1950s, Professors Merton Miller and Franco Modigliani proved that the stock market equates the value of a firm to the present value of the future cash flows available to the firm”s owners. Though this recipe for valuation seems quite simple, its execution can be difficult. Although the reported financial statements (e.g., the Income Statement, Balance Sheet, and Cash Flow Statement) do not capture the full picture of a company”s true financial performance, all of the necessary information is available. The Notes to the Financial Statements found in the 10-K and 10-Q documents provide important disclosures that affect the interpretation of the reported financial statements.

Here are details on how data from financial footnotes affects profits.

Here are details on how economic earnings differ from accounting earnings.

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