## Time Travel

Investing is a form of time travel. Investors know the past and the present but need to imagine the future. This isn’t a wishy-washy meta concept. It’s tangible. The value of any asset – what it’s worth – is the sum-total of the usability of the asset over its lifetime. In the case of investing, the usability is measured by cash flow. The value of an investable asset, therefore, is the sum-total of all the cash flows that asset will generate in the future, discounted of course. This applies to both stocks and bonds. It also applies to other assets like Real Estate. If you think about it applies to almost everything we buy. We don’t do math, explicitly, when we buy most things. But we usually have a “feeling” of the value of any object. When we pay a price for it, we usually pay no more than what we think is fair.

I apologize in advance – I’ll get into a bit of a Financy discussion here. But it's important to set the stage.

In the investing world, things get a bit more mathematical (although there are many investors who invest just with their “gut feeling”). In bonds, the math is straightforward. Bonds pay coupons, usually every 6 months, over the life of the bond. The coupons are known in advance – they’re contractual. The final payoff is known and contractual – it’s usually the principal amount. So, bond investors expect to get paid interest every 6 months, and then also get their money back at the end of the term. The final yield on the bond is the rate used to discount back all these known quantities. Easy math, except that there is the issue of Risk. In bonds, the main risk is this: not getting your money back, either partially or entirely. To compensate for that risk, the company or government entity issuing the bond pays a regular coupon (interest rate) and, based on the term of the bond, offers an implied yield. For example, in 2017 Netflix issued a $1.6 billion tranche of 4.875% Senior Notes that pays a coupon of, well, 4.875% split over two payments every year until 2028. This is a known fact. If Netflix doesn’t go belly up, it will repay the principal on that bond in 2028, or sooner if it refinances that tranche.

Stocks are a different beast. They’re riskier because other than current price, nothing else is known. Sometimes a dividend is sort of known. But even that’s not guaranteed – case in point: GE. Everything else – future revenue, earnings, cash flow etc. – are impossible to know. They can be estimated, or guesstimated based on historical numbers, expectations of the future of the industry in which the company operates, and hints we get from the company’s management in quarterly earnings calls. There is always a risk that the company can go kaput AND there is the issue of unpredictability if it doesn’t go belly up. Academics and the Wall Street crowd call this earnings volatility. So, to keep it simple, stocks have more layers of risk than bonds.

This same group of people – Academics and Wall-Street – uses math to adjust for these extra layers of risk in stocks. They normally do it in the discount rate. They guesstimate future cash flows (or in some cases earnings, which is an accounting number not firmly grounded in reality) over the next few years and into eternity and then discount that cash flow back to the “present value”. Discount rates have 3 main components:

- Inflation: The value of money decreases over time.
- Cost of Debt: Most companies borrow money, and so interest must be paid.
- Cost of Equity: A mathematical calculation of a proxy for stock-specific risk. This is supposed to take care of those things like unpredictability of cash flows.

So, back to the numerator: guesstimates of cash flows. You can visualize that the way the math works out is that higher the numerator, the higher the value of the firm. We know the cash flows over the last 12 months or the last few years. Those are facts. To guesstimate, analysts assume some growth rates which they attach to the historical numbers. These growth rate assumptions are a major (mathematical) driver of stock price calculations. These assumptions are a big deal. How big, you ask? One of my former professors – Jeffrey Williams – had quantified it many years ago:

*“Seventy percent of a company’s value is determined by efforts in place to refresh ageing products. The company’s price/earnings ratio is a measure of this: the degree to which current earnings are multiplied by the expectations that earnings can be sustained and improved.”* – Jeffrey Williams, Renewable Advantage.

When he says “…expectations that earnings can be sustained or improved”, he’s talking about growth assumptions. 70% of a firm’s calculated value is based on that. This is, of course, an average number over many companies, and the study is outdated. But the way this discounted cash flow models work, mathematically 70% is probably pretty close to the real number even today.