If everything is perfectly priced, why do stocks appreciate?
If a DCF is supposed to capture all future cash flows, every stock should currently be perfectly priced. So why do we expect stock prices to appreciate every year?
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A DCF makes tons of assumptions, you can't forecast with certainty 5 years into the future. Therefore the value derived from your DCF is just your opinion, which could be right or wrong.
You really think everything is perfectly priced with the amount of new/uneducated investors just dumping stimmy checks into random stocks and the Fed manipulating?
To add on to this the psychology of investors also plays a factor into the pricing of stocks. Check TSLA last year and it’s massive run up. The DCF is also assumption-laden as mentioned above, so it’s best to use it as a gauge rather than the end all be all. The reality is that markets aren’t perfectly efficient and certain stocks will see premiums while others won’t
Ever heard of cost of capital...specifically cost of equity?
First two posters are wrong, Associate 1 is right. "Everything priced perfectly" implies there is no arbitrage opportunities present in the market, hence you are fairly compensated for the risk you take on, no more no less. Assuming the CAPM holds, you are only rewarded for the market risk (systemic undiversifiable risk) you take on and make in expectation the cost of equity.
To answer your question more generally, under the risk neutral measure stocks earn the risk free rate, but under the objective measure ("real measure") anything is possible. The risk neutral measure is what matters when pricing securities, but that does not tell you what happens in the real world. And yes the DCF method is theoretically justified by and linked to standard risk-neutral pricing theory, most notably the fundamental theorem of asset pricing.
Could you explain the flaws in the reasoning of the first two posts?
The DCF method is built on sound mathematical grounds, it has nothing to do with it being your opinion or behavioural biases being present in the market (and even less as to why even in a perfectly priced market securities still earn a rate of return). To even use it means you have to assume the market is "perfect" (no arbitrage opportunites) already. Of course, the assumptions behind the method (and the market being perfect) are hardly if ever verified in practice, however it is a simple to teach and intuitive method hence why it is so widespread.
I’m the one who posted about the psychology of investors and its effect on prices. I misinterpreted your question. My answer pertains more to why stocks may trade
above/below implied “intrinsic” value derived from the DCF. Appreciation is a different ballgame and other posters have explained that well.
Stocks can appreciate when new information is revealed which was not priced in. For example, GDP was expected to grow 3% and it actually grew 5%...or a company was supposed to earn $100mm and ended up earning $130mm. A currently accurate price is only accurate based on information available. New information changes things.
Because fair value is defined to price in a return
Missed this before I wrote my response below but this is the easiest way to answer the question. Some flat out wrong answers in other comments.
Using your framework of a DCF, the reason that a company's stock price can go up even though it is perfectly priced is because the intrinsic value of the business increases.
For example, if you have a business that generates $100 in cash into perpetuity and your discount rate is 10%, this business would be worth $1000. Let's say the market prices this business perfectly at $1000. Now fast forward one year. At the end of Year 1, the business is now worth $1100 ($1,000 + $100 in cash that the business generated in Year 1). Let's say that the market prices the business perfectly once again at $1100. So even though the business was perfectly priced, the stock price would have gone up +10% because of the cash the business generated in Year 1.
Nothing is perfectly priced - efficient market hypothesis is a sham (sorry, Eugene).
Who marked this as inaccurate? Literally every time Thaler presents a clear counterexample Fama just waves it off with some comment to the effect of "there aren't enough anomalies shown to disprove my theory" or "I'm right because no one else has a better framework for understanding the markets."
Everyone giving overly complex answers to this. Here’s the easy answer: a DCF uses a discount rate that is above 0%. The stock is priced based on it moving at your discount rate. You’re literally discounting the cash flows to give yourself a return, hence the stock moves.
It has nothing to do with whether or not the stock is priced correctly, new information added later, or anything like that.
edit: whoever marked this as inaccurate is a dumbass
Market price is not equal to fair value for various reasons:
- Psychology of investors
- Information asymmetry
- External factors
- Different assumptions while running your DCF
- The structure of financial institutions, eg index funds have to buy a certain stock when it enters the S&P500, other funds have to divest a stock after it loses x%...
- The fact that it is easier for fund managers to get wrong on Apple than getting wrong on some small cap stock in Wisconsin which biases allocation of capital
- Markets are not perfect, ie there is market friction (trading fees, trading constraints), and limited liquidity in some cases
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