John, RE: your earnings model...
This makes the assumption that the market is efficiently pricing the security on a price/book basis in the first place. If this is the case, then individual security selection adds no value, and you're better off just indexing everything--which, BTW, I do not do.
(A quote from your post. How do I get it to print as italics?)
My model is not just an earnings model. I model all the critical parameters -- equity/share, earnings, dividends, and the price of the stock. Further, I make no assumptions about whether the market is pricing a stock efficiently or not.
I find what a stock is worth by adding the discounted values of all the cash that will flow into and out of my pocket as a result of buying the stock. Those cash flows are dividends, the net proceeds when I eventually sell the stock, taxes, and commissions.
That means I need to build a model that tracks a firm's dividends and stock price as closely as possible. I model actual stock prices, not theoretical prices. As part of the analysis I work out the price/book ratio which fits the stock's historical performance. That historical ratio contains whatever market inefficiencies were involved as the market priced the stock. I start my price/book forecast at the current ratio, and draw a free-hand forecast curve to reflect how I think that ratio will change as the growth firm matures. I make no assumptions about whether the market is pricing that stock efficiently. I only assume that the ratio is gradually heading towards some value appropriate for a mature firm.
I use my model to forecast dividends and the stock price when I eventually sell, then discount the net cash into my pocket at my opportunity cost plus a risk premium. I normally discount at several discount rates to develop a curve of the stock's value over a range of minimum acceptable rates of return. If the stock is worth more than it costs at a rate of return I believe acceptable for that stock, I consider buying it. If it costs more than it's worth, I go on to another stock.
John Malloy |
