This tricks me up when thinking about valuation. Say I am running a DCF and compute that the intrinsically justified share price is at ~140/Share.
Now to get to that share price I need to assume a discount rate/cost of capital, henceforth my expected return on this company would be at least the discount rate.
However, in this theoretical example, where would my return come from? Say my cash-flows ar eperfectly forecasted in T = 1 and assumptions do not change YoY, doesn't the price of the share then stay at 140 as everything is perfectly priced in ? Which means I am making 0% return?
You will earn the cost of equity if you own a fairly valued stock and assumptions around future CF/discount rate don't change in the interim.
Stocks are priced to give you a return. "Fairly valued" doesn't mean the price doesn't move, it means it is priced fairly to give you the required return on equity.
A simplistic example - if a stock is expected to pay you $10 in free cash flow per year, which is never expected to grow, and the cost of equity is 10%, the stock will be "fairly valued" in your DCF at $100. Fast forward one year, the stock is still $100, but you've collected $10 of FCF (10%) which either could be paid to you via dividend or buyback, or used towards M&A or deleveraging which would proportionately increase the value of your equity. I.e. your return would be 10%.
As a company is expected to grow more, an increasing portion of your return will be tied to the discounting of future cash flows. In which case you will earn your return from collecting the next year's FCF like the above example, combined with the fact that future FCFs increase in value by 10% each year because you are a year closer to receiving them.
There's no such thing as a "fairly valued company" -- that's just an academic abstract benchmark that can't literally exist, because you and I will always have different views on the company's future growth so we'll disagree on the fair value. And if you think it really is "fairly valued" then there's no excess profit to be made, so why would you bother buying that company instead of something with more opportunity?
I presume you work at an active manager like me. You’ve really never come across a name where you go “yep, seems fair” and move on to the next thing? I encounter this literally all the time. Maybe daily. The industry is humbling in how good markets are at pricing most securities.
It doesn’t matter that me and you have diverging views on whether a specific security is over/undervalued. What matters is that the average of everyone’s opinion generally results in a price that is “fair” given all available information and probabilities of future outcomes.
Alternatively, if you buy a stock you believe to be undervalued, just because it generates an excess return does not mean the stock wasn’t fairly priced when you bought it. It could just be that the 20% upside outcome that was incorporated into the price at your purchase occurred. Meaning you’re just lucky vs having actual edge over other market participants. Which is why on average stocks are fairly priced…. over a larger number of investments you make (ie where a sufficient number of different probabilities have had a chance to play out) you generally will match or underperform the market on average.
Yes, and that's literally exactly what I said in my post. "if you think it really is 'fairly valued' then there's no excess profit to be made, so why would you bother buying that company instead of something with more opportunity?"
Your first sentence was that there’s no such thing as a fairly valued company. My response was intended to illustrate that I disagree and most companies are fairly valued.
Isn’t the point to play for the tail outcomes? Base case =fairly valued but you’re taking a bet on the how the probability skewed in favor of either the upside or downside. Then you amass a quantity of bets where your longs have more probability of hitting its bull case vs bear case then vice versa for your shorts.
Yeah but stocks aren’t priced based on a singular estimate of the future, prices are based on a range of outcomes and their perceived probabilities. The average return based on the probability-weighted range of future outcomes = the required return on equity if a stock is fairly priced. If you think there’s a higher probability of a “good” outcome vs what is priced then you think a stock is undervalued. It’s impossible to tell whether or not that was actually the case or you were just lucky in hindsight, but to your point over a sufficiently large number of bets you can draw some conclusions about whether or not you have better than average judgment.
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