And to further explain, if you don’t increase your near-term profits/shift priorities from future growth to present returns as interest rates increase, under the discounted FCF model your current value decreases. AKA the price of the stock goes down, which shareholders and executives tend not to like.
You can think of the value of a stock being the value of all the future profits. So if I know that a company will make $100m in it's lifetime, I can say that company should be worth $100m. But we have to discount that - because money in the future is generally worth less than money today. If I give you a dollar today, you have a dollar, you put it in the bank and collect interest and next year you'll have $1.02 (2% interest). If I give you a dollar next year, you have a dollar. So the dollar today is clearly more valuable than the dollar next year. So what we have to do is look at when the company will make that money, and discount what that money in the future back to what it's value is now. "This is the net present value of future cash flows"[1]. So as interest rates go up, we apply bigger discounts, so companies whose profits won't come for a long time get heavily penalized by this in their valuation.
There's a pretty good technical illustration of how the discount rate impacts stock prices here [0].
This does provide one plausible answer to the headline question from TFA: Corporations' expected future profits are lower than they were pre-COVID, but the valuation discount rate is lower because the expected future return for assets in general is lower, so the present value of corporations' expected future profits is the same-ish as it was pre-COVID.
You don’t need to predict the future. The fair value of a company is the discounted future cash flows. Increase the discount rate and the valuation falls
True, but valuations are based on future earnings potential. If the market looks down, then there is the idea that there is less revenue coming in the future, and the company has less capability to sustain a workforce.
Stock prices should equal the future discounted stream of a firm's cash flow. A free option for the sole product that you produce will certainly lower the long-term prospects of profitability.
If short term profit drops but the consensus DCF of future activities rises, the share price is likely to go up. (That’s where preparing for the future creates shareholder value.)
On the other side, it happens all the time that a company has a single blowout quarter and the shares fall.
The thing is, in the formula, you have to use the rate "r" to discount the future profits. If the "r" decreases, the monetary value of stocks in the present increase, even though the cashflow has not changed. So, even if coronavirus decreases short-term profits, the effect it has on the global economy can lower interest rates, causing the present value of stocks to increase.
> stock market should have no volatility in share prices whatsoever - it should fairly value each company based on their profits over the next 15 to 20 years
Computing this depends on estimating/forecasting/extrapolating/guessing a lot of values. E.g. what kind of revenue growth the company will have. How the structure of company expenses may change. Parameters like a discount rate make a huge difference in the estimated value. In many cases the majority of the value for a discounted cash flow valuation of a stock comes from the tail term where you give up trying to unroll the contribution for each year and make a simpler approximation of what the company will be doing 20 years+ in the future.
The computed share value has a lot of sensitivity to adjusting some of these inputs, and in many cases it is not at all obvious what values parameters should be set to.
Asset prices are inversely correlated to interest rates, so companies can raise more capital by selling shares when rates are low than when they’re high.
If company X's price is currently $100, but it's projected future profits discounted to the present day is $90, then why wouldn't you sell, regardless of the purchase price?
In the long term, a company's value is usually considered to be the discounted future cash flows. Stock price is often vaguely, if at all, correlated with this number.
You're mistaking assets and equity. A 40% discount in asset value absolutely would wipe out shareholders. To be a bit blunt, given your thesis here I would advise against trading in individual stocks, at least in the banking sector.
Sounds like: stock price is high so use its value to its full extent while the price is high and more valuable. Allows selling/granting of fewer shares of stock too.
Well technically a company's stock value is supposed to represent the discounted present value of all future profits. So you can interpret a reduction in stock price as an indication that the market expects profits to be lower in the future.
Well, minus a discount for however long you think it will take before that actually happens, taking into account such things as inflation, interest rates, and market performance (due to the opportunity costs of holding this stock until then).
This. The value of a stock should (in theory) be based on discounted cashflow with the emphasis on cash. A company can generate massive earnings but if it needs to invest huge amounts of capital to support those earnings then it should have a lower valuation.
reply