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Strategies & Market Trends : Gorilla and King Portfolio Candidates
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To: Pirah Naman who wrote (43543)6/15/2001 9:33:29 PM
From: Stock Farmer  Read Replies (2) of 54805
 
Hi Priah - Pricing is important. Because it's the price you pay when you buy, and the price that gets paid when you sell.

But for the life of me, I can't understand why folks insist on using pricing algorithms that depend on the price!

For example, taking previous PE (or PEG or P/S or... ), factoring in new E (or EG or S or...) and multiplying to get P. Such a mechanism is subject to runaway systemic error.

Imagine a price formula: P(n) = F(n) * P(n-1) where P(x) is price in interval x, and F(x) is some function

A little high school algebra tells us P(n+1) = F(n+1) * P(n)

Or P(n) = F(n) * F(n-1) * F(n-2)... * F(1) * P(0)

This is exposed to three sources of systemic error

(a) Any random error in P(0) is carried unattenuated throughout
(b) Any random error F(x) is similarly carried unattenuated
(c) Any systemic error in F itself compounds geometrically! (do the words "mania", or "bubble" ring a bell?)

Leaving the realm of theory, try PE was 100, E is now $0.20 so P should be $20. This assumes

(a) P was not inflated back then when PE was 100
(b) PE is a linear function of E
(c) E is $0.20 not $0.196

Now, normally in a system you will get upside and downside errors and things will cancel themselves out. But the stock market is a peculiar beast. It is fundamentally optimistic (why else would you buy something for $20 that is only worth $0.20 today). So systemic errors tend to be biased to the upside.

This explains the hyperbolic nature of bubbles and their subsequent bursting.

So for a pricing mechanism I try to use a price-independent valuation method and then create a price.

(Yes, I was just yanking your chain)

Discounted Future Cash Flows works for me. I like this method because

(a) it is remarkably robust against financial engineering
(b) it is linked to something that really matters: cold cash from operations after all puts and takes are accounted for
(c) It is meaningfully comparable from company to company
(d) It is fundamentally economically sound
(e) It can be readily computed from available data and simple assumptions

Admittedly, it does not lend itself well to three-second-sound bite snippets. It requires more than a few neurons rubbed together to get right. With all the folks running around misusing the term "Gorilla" I'm sure the good people on the thread agree that a little knowledge is a dangerous thing.

But, for folks with the patience and skill to accurately discern princes from kings from gorillas... DCF shouldn't be that difficult.

John.
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