Chapter 8

Interpreting Market History

For the last four decades, we have been in quest of a better idea of value, consistent with the reality that the market always seeks value. This value focus forms the basis of stock investing.

Let's think about this for a couple of minutes and maybe do a quick review. Academics writing books and investors building models always have felt that discounted cash flow isn't accurate, and so it can't be used. Thus, it is smart to move on to other factors.1 That movement has led to all this work on helping earnings function more effectively as the basic measure.

With earnings, the academics and investors need a margin of safety, so they add business factors, financial factors, and multiples to the P/E ratio to make a buy decision.

Equation 8.1 The Price Equation


Our focus for a moment is on simplified pricing (Equation 8.1). One recent book has the professor-author trying to deal with the classic problem of how to measure risk. It is universally acknowledged that every investment contains risk, including discounting cash flow. Should the risk be in the numerator cash flow of the pricing equation, or in the denominator discount rate? This professor uses a discount rate to create a price to earnings ratio (P/E), with the E no longer current earnings but instead the present value of an earnings growth factor. We believe this illustrates the classic ...

Get ValuFocus Investing: A Cash-Loving Contrarian Way to Invest in Stocks now with O’Reilly online learning.

O’Reilly members experience live online training, plus books, videos, and digital content from 200+ publishers.