# Best practices in stock market investing

Posted by **John T. Reed** on

A reader below said NPV is the way to evaluate a stock, not P/E ratio.

.

I will let my other readers decide—after I translate the terms into Plain english.

.

NPV means net present value. I learned that in the CCIM course before I went to Harvard Business. We needed to understand it at Harvard to analyze some of our cases there. I felt sorry for my Harvard classmates who had no clue about time value of money (of which NPV is a subset—new MBA students there with no financial background have to attend a sort of pre-school on financial math and such there in August before they enter nowadays).

.

The net present value calculation is the present value of all the future cash flows minus what you pay for the asset up front. In a stock, that means you would predict future income from the stock in the form of dividends and sale price of the stock when you get rid of it. Then you discount those in-flows to get their present value because money to be received later is worth less than money to be received or paid out now yadda yadda.

.

You could also calculate the NPV from the perspective of the corporation in question looking at earnings rather than dividends.

.

There are two huge problems with NPV. 1. You need a crystal ball to forecast future earning/dividends/stock price and you do not have one. 2. To calculate the present value of money to be received in a future year, you must choose a discount rate. If you choose a low discount rate, the NPV jumps way up. If you choose a high discount rate, it falls way down.

.

Can you ask the market what is the right discount rate? Hell no! The discount rate is sort of an upside down P/E ratio. My complaint is the market is overvaluing stocks like Amazon and Tesla as evidenced by their ridiculous P/E ratios. Turning to an NPV based on an apparent market discount rate to get the “right” answer is essentially asking the same idiots who are buying at P/E ratios of 101 what the correct value of the stock is.

.

P/E ratio, in contrast, is not crystal-ball gazing. It is the current actual stock price divided by last year’s or recent years’ actual earnings. There is no all-important, but un-nail-down-able, discount rate involved.

.

The P/E ratio simply tells you how much the stock is selling for in relation to the recent, not projected, profits of the corporation—a common sense way to simplify a complex pile of data.

.

Can you use P/E ratio if the company in question has not yet had any net earnings—like Tesla? Sure. But the result you get is the company is worthless. Idiots who buy Tesla stock do not want to hear that. Thus do we have all these tortured, convoluted denunciations of P/E ratios and B school professors, etc.

.

NPV has a big GIGO problem—garbage in garbage out. A chain is only as strong as its weakest link. NPV includes links based on assumptions about future earnings, dividends, and stock price. Assumption is the mother of all screw-ups. NPV also includes an all important discount rate—which is another assumption.

.

P/E ratio has no assumptions. And comparison to the long-term historical average (13) is a valid test. To say otherwise is the ominous “But this time is different” excuse for failing that test. There is a book by that title by Reinhart and Rogoff. It starts with the Wall Street warning that more money has been stolen using the words “This time is different” than the words “Your money or your life.”

.

There is arguably a “regression to the fundamentals” phenomenon in investment assets. Because of irrational exuberance and irrational despair at times, asset values fluctuate widely—which can inflate or devastate your net worth. But like the pendulum’s regression to the mean (average value of pointing straight down), asset values seem to me to eventually regress toward the value indicated by fundamentals like P/E ratio. In other words, the irrationality occasionally disappears when people notice the stock they shunned has been paying great dividendes that they missed out on.

.

You can endlessly find fault with metrics like P/E ratios, and those who own or recommend stocks that suck with regard to P/E ratios DO endlessly find fault with them. You can also always find some off-the-wall metric like price-to-sales ratio back in the dot-com boom that make a horseshit stock look good, and the buyers and recommenders of horseshit stocks do just that.

.

If you happen to own stocks during a period of irrational exuberance—AND GET OUT BEFORE IT ENDS—you will make money. But neither I nor anyone else has any expertise on predicting irrationality or the end of irrationality.

.

I only recommend best practices like holding down costs like management fees and transaction fees and income taxes and buying assets with good fundamentals and making sure you can stay liquid enough to hold them long enough to benefit from their eventual regression to their fundamental value mean.

.

I will let my other readers decide—after I translate the terms into Plain english.

.

NPV means net present value. I learned that in the CCIM course before I went to Harvard Business. We needed to understand it at Harvard to analyze some of our cases there. I felt sorry for my Harvard classmates who had no clue about time value of money (of which NPV is a subset—new MBA students there with no financial background have to attend a sort of pre-school on financial math and such there in August before they enter nowadays).

.

The net present value calculation is the present value of all the future cash flows minus what you pay for the asset up front. In a stock, that means you would predict future income from the stock in the form of dividends and sale price of the stock when you get rid of it. Then you discount those in-flows to get their present value because money to be received later is worth less than money to be received or paid out now yadda yadda.

.

You could also calculate the NPV from the perspective of the corporation in question looking at earnings rather than dividends.

.

There are two huge problems with NPV. 1. You need a crystal ball to forecast future earning/dividends/stock price and you do not have one. 2. To calculate the present value of money to be received in a future year, you must choose a discount rate. If you choose a low discount rate, the NPV jumps way up. If you choose a high discount rate, it falls way down.

.

Can you ask the market what is the right discount rate? Hell no! The discount rate is sort of an upside down P/E ratio. My complaint is the market is overvaluing stocks like Amazon and Tesla as evidenced by their ridiculous P/E ratios. Turning to an NPV based on an apparent market discount rate to get the “right” answer is essentially asking the same idiots who are buying at P/E ratios of 101 what the correct value of the stock is.

.

P/E ratio, in contrast, is not crystal-ball gazing. It is the current actual stock price divided by last year’s or recent years’ actual earnings. There is no all-important, but un-nail-down-able, discount rate involved.

.

The P/E ratio simply tells you how much the stock is selling for in relation to the recent, not projected, profits of the corporation—a common sense way to simplify a complex pile of data.

.

Can you use P/E ratio if the company in question has not yet had any net earnings—like Tesla? Sure. But the result you get is the company is worthless. Idiots who buy Tesla stock do not want to hear that. Thus do we have all these tortured, convoluted denunciations of P/E ratios and B school professors, etc.

.

NPV has a big GIGO problem—garbage in garbage out. A chain is only as strong as its weakest link. NPV includes links based on assumptions about future earnings, dividends, and stock price. Assumption is the mother of all screw-ups. NPV also includes an all important discount rate—which is another assumption.

.

P/E ratio has no assumptions. And comparison to the long-term historical average (13) is a valid test. To say otherwise is the ominous “But this time is different” excuse for failing that test. There is a book by that title by Reinhart and Rogoff. It starts with the Wall Street warning that more money has been stolen using the words “This time is different” than the words “Your money or your life.”

.

There is arguably a “regression to the fundamentals” phenomenon in investment assets. Because of irrational exuberance and irrational despair at times, asset values fluctuate widely—which can inflate or devastate your net worth. But like the pendulum’s regression to the mean (average value of pointing straight down), asset values seem to me to eventually regress toward the value indicated by fundamentals like P/E ratio. In other words, the irrationality occasionally disappears when people notice the stock they shunned has been paying great dividendes that they missed out on.

.

You can endlessly find fault with metrics like P/E ratios, and those who own or recommend stocks that suck with regard to P/E ratios DO endlessly find fault with them. You can also always find some off-the-wall metric like price-to-sales ratio back in the dot-com boom that make a horseshit stock look good, and the buyers and recommenders of horseshit stocks do just that.

.

If you happen to own stocks during a period of irrational exuberance—AND GET OUT BEFORE IT ENDS—you will make money. But neither I nor anyone else has any expertise on predicting irrationality or the end of irrationality.

.

I only recommend best practices like holding down costs like management fees and transaction fees and income taxes and buying assets with good fundamentals and making sure you can stay liquid enough to hold them long enough to benefit from their eventual regression to their fundamental value mean.

### Share this post

0 comment