I don’t understand the valuation of some companies – what am I missing?

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Virus4762
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I don’t understand the valuation of some companies – what am I missing?

Post by Virus4762 » Sun Oct 06, 2019 8:05 am

I’m trying to hone my financial statement evaluation abilities but I feel like there’s a lot I’m missing because I don’t fully understand the valuation of some companies. I know it’s possible for a company to be overvalued but the kind of companies I’m talking about have valuations that don’t even seem like they could be explained away by simply saying that the company is merely “overvalued”. Let me explain, take the technology company VeriSign. VeriSign has a P/E ration of 36.45 despite having a 3-year revenue growth average of 4.67% (with expected future growth also in that range). Now compare VeriSign with a company like Visa – a company with equally as impressive margins but one that has a 3-year average revenue growth of almost 15% percent (with expected future growth also in that range) – that is trading at a similar P/E. True, VeriSign has margin growth but so does Visa. The two companies’ cash flows are a break also (cash flows to price ratio). As far as the balance sheet is concerned, VeriSign has a much better asset turnover than Visa but the company has extremely negative equity whereas Visa has a modest 2 to 1 leverage ratio – so I feel like Visa actually has the better balance sheet. However, Warren Buffett, the archetypal value investor, owns VeriSign. I don’t understand the reasoning behind the valuation. Is it because one of VeriSign’s main business activities is the providing of domain name registry services making the company semi-“recession-proof” (the stock lost more than half its value in 2008 so it couldn’t be that recession proof)? Or is there some other valuation metric that I’m overlooking, warranting the company’s rich valuation? Even if the reason for the rich valuation is that the company is valued as a staple, then I still don’t understand how the company’s extreme negative equity (https://financials.morningstar.com/rati ... atform=sal) isn’t a red flag. Or is a company having negative equity not that big of a deal? <---I guess this is another topic entirely but it's actually something else I'm baffled about because, surprisingly to me, the market doesn't ever seem to care that much when a company has negative equity.

Maybe I chose the wrong example and the “staple” valuation of VRSN explains the valuation above but that can’t explain the hordes of valuation discrepancies in the market. Take the following three groups of companies:

TEAM vs. WIX/DBX
INTU vs. MSFT/XLNX
NCR vs. ORCL
QRVO vs. TXN

The latter name in each group of these four groups has similar or superior past and expected future earnings growth, margin growth, cash flows per net income, and leverage than the former name yet the former name in each group has a much higher P/E ratio. I could go on and on listing companies. The frequency of these value differences makes it obvious it isn’t just mispricings by the market. What am I missing? Thanks.

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JoMoney
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Re: I don’t understand the valuation of some companies – what am I missing?

Post by JoMoney » Sun Oct 06, 2019 9:46 am

If you don't understand why it's valued the way it is, it could be mis-priced, or it could just be in the category Buffett would call "too hard".

Obviously there are other participants in the market with a different perspective on its growth prospects. Those decisions might be more influenced on a "greater fool theory" style, or they may be more informed about upcoming changes in that market space that you don't see.
I'm sure there are other factors that within your personal mental framework you don't see (or discount too meaningless noise) that someone else believes is an important predictive indicator.
"To achieve satisfactory investment results is easier than most people realize; to achieve superior results is harder than it looks." - Benjamin Graham

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Re: I don’t understand the valuation of some companies – what am I missing?

Post by cableguy » Sun Oct 06, 2019 10:06 am

There are many companies, in and out of the S&P 500, that are overvalued. However, what we learned in business and economics classes when we were in college really doesn’t apply in current times. Manipulated interest rates, not market based rates, push investors to buy riskier assets such as over priced stocks and real estate. Crazy accounting rules and regulations allow companies with huge amounts of debt on their balance sheets to take their excess cash and buy back their stock instead of paying down their debt. We see companies borrowing money to pay dividends and buy back their stock! Our government has something called the Plunge Protection Team, which will buy stocks when the markets go down too much.

[OT comment removed by moderator oldcomputerguy]

wootwoot
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Re: I don’t understand the valuation of some companies – what am I missing?

Post by wootwoot » Sun Oct 06, 2019 10:13 am

It's likely due to the low interest rate bubble that the fed has created. Fundamental analysis is dead in the water and means very little for tech companies right now. It won't be this way forever.

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Re: I don’t understand the valuation of some companies – what am I missing?

Post by MathIsMyWayr » Sun Oct 06, 2019 10:49 am

The true valuation of a company is more than a collection of a small set of numbers. Trying to beat the market is a futile task at best.

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Re: I don’t understand the valuation of some companies – what am I missing?

Post by Whakamole » Sun Oct 06, 2019 10:56 am

wootwoot wrote:
Sun Oct 06, 2019 10:13 am
It's likely due to the low interest rate bubble that the fed has created. Fundamental analysis is dead in the water and means very little for tech companies right now. It won't be this way forever.
It's not just interest rates. I've heard the term "everything bubble" which seems to be applicable.

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nedsaid
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Re: I don’t understand the valuation of some companies – what am I missing?

Post by nedsaid » Sun Oct 06, 2019 11:13 am

There is a big difference between book value per share, the value of a company as calculated by the accountants, and price per share determined by the markets. I have posted on this topic many times and have used Microsoft as an example. Going from memory, Microsoft has a book value of about $9 to $10 a share but the markets value the company at about $130 a share. Dude, that is a big difference.

Some reasons for this. Businesses have a liquidation value, that is the value if you closed the doors and sell all the assets and pay off all the debt. In the real world, businesses take on a life of their own, the whole is worth more than the sum of its parts. The accountants call this going concern. A business develops products, develops loyal customers, and builds a reputation in the marketplace. Hard to put a number on that as all of that is intangible. Better to mostly value a company on the basis of its cash flows. Consistent earnings deserve a higher earnings multiple than volatile earnings. Higher rates of consistent growth deserve higher earnings multiples than lower rates of consistent growth. The balance sheet is still important, the market places a premium on companies with strong balance sheets compared to weaker balance sheets, the balance sheet is less important to valuations. The key is how well the company can service its debt.

There are also such things like patents, copyrights, intellectual property which is also difficult for the accountants to measure the value of. The market takes all this into account when setting the stock price.

My take is that something is happening that the markets perceive which the accountants can't capture. Companies have an increasing reliance upon intangible assets such as intellectual property and a decreasing reliance on property, plant and equipment. One reason that companies seem "overvalued" today. Also, profit margins have been high compared to history and this has tended to higher P/E ratios as well.

I wouldn't say markets are cheap here, they are not. I would say that the US Stock Market is not as expensive as it looks. Very low interest rates also tend towards higher P/E ratios. What we are seeing is not irrational.
A fool and his money are good for business.

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Re: I don’t understand the valuation of some companies – what am I missing?

Post by Virus4762 » Sun Oct 06, 2019 11:36 am

nedsaid wrote:
Sun Oct 06, 2019 11:13 am
My take is that something is happening that the markets perceive which the accountants can't capture. Companies have an increasing reliance upon intangible assets such as intellectual property and a decreasing reliance on property, plant and equipment. One reason that companies seem "overvalued" today.
Would you argue that this gives the average company in the stock market a lower book value (in relation to the price of the company) compared to, say, 30 years ago? An increased reliance of PP&E wouldn't necessarily require a company to have a greater book value.

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Virus4762
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Re: I don’t understand the valuation of some companies – what am I missing?

Post by Virus4762 » Sun Oct 06, 2019 11:39 am

wootwoot wrote:
Sun Oct 06, 2019 10:13 am
It's likely due to the low interest rate bubble that the fed has created. Fundamental analysis is dead in the water and means very little for tech companies right now. It won't be this way forever.
This doesn't explain why some companies seem to be overvalued while others do not, though.

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Re: I don’t understand the valuation of some companies – what am I missing?

Post by eye.surgeon » Sun Oct 06, 2019 11:47 am

Since I own the whole market the valuation of any one particular stock doesn’t trouble me too much.
"I would rather be certain of a good return than hopeful of a great one" | Warren Buffett

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Re: I don’t understand the valuation of some companies – what am I missing?

Post by nedsaid » Sun Oct 06, 2019 11:50 am

Virus4762 wrote:
Sun Oct 06, 2019 11:36 am
nedsaid wrote:
Sun Oct 06, 2019 11:13 am
My take is that something is happening that the markets perceive which the accountants can't capture. Companies have an increasing reliance upon intangible assets such as intellectual property and a decreasing reliance on property, plant and equipment. One reason that companies seem "overvalued" today.
Would you argue that this gives the average company in the stock market a lower book value (in relation to the price of the company) compared to, say, 30 years ago? An increased reliance of PP&E wouldn't necessarily require a company to have a greater book value.
Yep, that is exactly what I am saying. Book value is of decreasing importance. No one cares about the value of Microsoft's real estate, the great majority of the company's value is in the value of its intellectual property and in its ability to generate vast amounts of cash. Pretty much we have seen a shift away from the industrial economy to the information economy. Of course, we will always need to make things, so manufacturing will never go away but it is a decreasing portion of Gross Domestic Product. Book value is still important, the most important thing is the debt load and the ability of a company to service it.
A fool and his money are good for business.

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Virus4762
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Re: I don’t understand the valuation of some companies – what am I missing?

Post by Virus4762 » Sun Oct 06, 2019 1:23 pm

nedsaid wrote:
Sun Oct 06, 2019 11:50 am
Yep, that is exactly what I am saying. Book value is of decreasing importance. No one cares about the value of Microsoft's real estate, the great majority of the company's value is in the value of its intellectual property and in its ability to generate vast amounts of cash. Pretty much we have seen a shift away from the industrial economy to the information economy.
But what does It matter if a majority of a company's assets are in PP&E or in cash/short-term investments? That wouldn't have any relation to the equity of a company.

Or are you trying to imply that companies in the past had a lower return on assets?

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Re: I don’t understand the valuation of some companies – what am I missing?

Post by Stereofun » Sun Oct 06, 2019 2:24 pm

Perhaps we are today surfing waves between normal and "new normal" - making it harder to be an investor and understand what is going on. If we truly are in unprecedented territory with regard to interest rate manipulation, money supply expansion and the confluence of politics and markets - then the question becomes, how long time can "this time is different" last - and if it lasts long enough - will investors begin to accept it as a new normal and a fundamental paradigm shift.

I do think the fundamental physics of economics will materialize - of course they will - but they might go on for far far longer than what looking to the past indicates.

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Re: I don’t understand the valuation of some companies – what am I missing?

Post by KyleAAA » Sun Oct 06, 2019 2:42 pm

I think of Verisign as a utility of the Internet. It runs I think 2 or 3 of only a handful of root nameservers. I don’t think Visa and Verisign really have anything in common so I’m not sure why one would expect similar valuations. Ditto with your other comparisons. What does Atlasssian have in common with WIX and Dropbox or Intel with Microsoft?

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Re: I don’t understand the valuation of some companies – what am I missing?

Post by Virus4762 » Sun Oct 06, 2019 2:58 pm

KyleAAA wrote:
Sun Oct 06, 2019 2:42 pm
What does Atlasssian have in common with WIX and Dropbox or Intel with Microsoft?
I wasn't trying to imply that I think they're the same type of company...but I was assuming that Atlassian isn't necessarily a safer company to invest in than WIX/Dropbox - and that Intuit isn't necessarily a safer company to invest in than Microsoft. Would you disagree?

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Re: I don’t understand the valuation of some companies – what am I missing?

Post by Broken Man 1999 » Sun Oct 06, 2019 3:15 pm

I think for the most part stocks are not priced by financials/metrics of the stock, but rather opinion, feelings, etc.

Why else would a stock like Apple gain/lose 10% in share price over short periods of time?

We hope the share price will increase, but I see no evidence that it is anything but hope. I certainly can't point to financials/metrics to explain such short-term repricing.

Broken Man 1999
“If I cannot drink Bourbon and smoke cigars in Heaven than I shall not go. " -Mark Twain

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Re: I don’t understand the valuation of some companies – what am I missing?

Post by nedsaid » Sun Oct 06, 2019 3:20 pm

Virus4762 wrote:
Sun Oct 06, 2019 1:23 pm
nedsaid wrote:
Sun Oct 06, 2019 11:50 am
Yep, that is exactly what I am saying. Book value is of decreasing importance. No one cares about the value of Microsoft's real estate, the great majority of the company's value is in the value of its intellectual property and in its ability to generate vast amounts of cash. Pretty much we have seen a shift away from the industrial economy to the information economy.
But what does It matter if a majority of a company's assets are in PP&E or in cash/short-term investments? That wouldn't have any relation to the equity of a company.

Or are you trying to imply that companies in the past had a lower return on assets?
You have to make a distinction between the book value as calculated by the accountants and market value as set collectively by market participants. The accountants say that Microsoft is worth about $10 a share and the market participants say that the company is worth $130 per share. The $120 or so gap is not captured on the books but it is real nonetheless, the value of the stock is currency that Microsoft can use to make acquisitions. If somehow the accountants had been able to capture that $120 on the books, a lot of items that went to expense would have instead been capitalized thus making Microsoft's earnings during those years even higher. These capitalized costs would have included the costs of developing the Windows and Office franchises but of course there is no way the accountants could have known in advance the value of those franchises or even that those franchises would succeed. So in a way, I am saying that perhaps the earnings were understated.

Do modern companies have a higher rate of return than companies in the past? Great question. What I will say is that profit margins are still near all time highs, hard to say if those high margins are sustainable. What I will say is that increases in productivity do increase returns, more output per unit of work. I wonder if productivity numbers are similarly understated. I am making the point that intangible assets are gaining in importance and that tangible assets are declining in importance. Intangible assets are more a factor in earnings production than tangible assets. I suppose a company could be virtual, where everyone works at home.
A fool and his money are good for business.

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Re: I don’t understand the valuation of some companies – what am I missing?

Post by nedsaid » Sun Oct 06, 2019 3:42 pm

JoMoney wrote:
Sun Oct 06, 2019 9:46 am
If you don't understand why it's valued the way it is, it could be mis-priced, or it could just be in the category Buffett would call "too hard".

Obviously there are other participants in the market with a different perspective on its growth prospects. Those decisions might be more influenced on a "greater fool theory" style, or they may be more informed about upcoming changes in that market space that you don't see.
I'm sure there are other factors that within your personal mental framework you don't see (or discount too meaningless noise) that someone else believes is an important predictive indicator.
I would say that markets are mostly efficient though not perfectly so. There are companies out there whose stock price compared to financials just don't seem to make sense, that is where speculation comes in. Perhaps the stock is being priced like a lottery ticket which has the potential for a large pay-off if everything goes right. There are pockets of speculation in the stock market.
A fool and his money are good for business.

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Re: I don’t understand the valuation of some companies – what am I missing?

Post by Scooter57 » Sun Oct 06, 2019 3:48 pm

With stocks linked together in a great number of ETFs organized by sector, metrics, and a wide range of other at times obscure ways of arranging them, the price of individual stocks can rise and fall with little relation to the actual performance of the company. The proliferation of ETFs since the Financial Crisis has changed the way that stocks perform.

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Re: I don’t understand the valuation of some companies – what am I missing?

Post by nedsaid » Sun Oct 06, 2019 3:53 pm

Scooter57 wrote:
Sun Oct 06, 2019 3:48 pm
With stocks linked together in a great number of ETFs organized by sector, metrics, and a wide range of other at times obscure ways of arranging them, the price of individual stocks can rise and fall with little relation to the actual performance of the company. The proliferation of ETFs since the Financial Crisis has changed the way that stocks perform.
We have had vehicles like open ended and close ended mutual funds for a long time, they go back to the 1920's and Investment Trusts before then. How have ETFs changed trading patterns that mutual funds did not? Also, there have always been speculators that make bets in the market that aren't transparent to other market participants. My guess is that the proliferation of ETFs have helped drive up trading volumes but not sure they have changed the actual behavior of the markets.
A fool and his money are good for business.

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Re: I don’t understand the valuation of some companies – what am I missing?

Post by rkhusky » Sun Oct 06, 2019 7:00 pm

If one is sure that a stock is mispriced, there is a sure fire way to test that theory. But remember that the market can stay irrational longer than you can stay solvent. And if the market seems to be irrational for years, perhaps it’s not really irrational.

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Re: I don’t understand the valuation of some companies – what am I missing?

Post by KyleAAA » Sun Oct 06, 2019 7:13 pm

Virus4762 wrote:
Sun Oct 06, 2019 2:58 pm
KyleAAA wrote:
Sun Oct 06, 2019 2:42 pm
What does Atlasssian have in common with WIX and Dropbox or Intel with Microsoft?
I wasn't trying to imply that I think they're the same type of company...but I was assuming that Atlassian isn't necessarily a safer company to invest in than WIX/Dropbox - and that Intuit isn't necessarily a safer company to invest in than Microsoft. Would you disagree?
I don't think lower valuation implies safety.

Although Atlassian is totally safer that Wix. Wix is a ness.

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Re: I don’t understand the valuation of some companies – what am I missing?

Post by whodidntante » Sun Oct 06, 2019 8:55 pm

For what it's worth, Morningstar agrees that VeriSign is overvalued, and assigns a fair value of 136, or about 36% overvalued. But the company has a wide moat, according to the analyst.
The key intangible asset VeriSign holds is the exclusive rights to .com and .net top-level domains. The .com and .net domains are the first and fifth most popular domains by market share (40% and 4%, respectively). VeriSign is granted exclusive rights to act as the registry for these domains by ICANN. The contract runs for six years and has a "presumptive right of renewal" clause which renews for an additional six years assuming VeriSign maintains its service level agreements over the term of the contract.

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Re: I don’t understand the valuation of some companies – what am I missing?

Post by Virus4762 » Sun Oct 06, 2019 11:16 pm

KyleAAA wrote:
Sun Oct 06, 2019 7:13 pm

I don't think lower valuation implies safety.

Although Atlassian is totally safer that Wix. Wix is a ness.
Well ya, I meant that if a company has a higher valuation based on just the numbers then one reason could be because it's a safer investment. I'm glad to hear you say that Atlassian is a safer investment than Wix because that's likely the explanation for the valuation difference. How is Wix a mess? Would you mind telling me what metrics you're referring to? I'm curious what it is I'm missing on their financials.

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Re: I don’t understand the valuation of some companies – what am I missing?

Post by not4me » Mon Oct 07, 2019 9:08 am

Virus4762 wrote:
Sun Oct 06, 2019 8:05 am
I’m trying to hone my financial statement evaluation abilities but I feel like there’s a lot I’m missing because I don’t fully understand the valuation of some companies.
...

The frequency of these value differences makes it obvious it isn’t just mispricings by the market. What am I missing? Thanks.
If you are looking for a single explanation, I don't think you'll find it. The "value" differences are not always a function solely of the financials 1st of all. I looked quickly at the 1st two you mentioned: Verisign & Visa. They both seem to be treated as large cap growth; but then the differences mount up. Perhaps the most significant: Verisign is a tech company, Visa a financial. There are many others that may contribute to lesser degrees & thus why I say no single answer.

That being said, I looked at the Enterprise Value / EBITDA & saw where they were very close (Verisign - 27.38, Visa - 27.22) according to the source I used. I would expect that is more coincidence than a persistent pattern though.

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Re: I don’t understand the valuation of some companies – what am I missing?

Post by KyleAAA » Mon Oct 07, 2019 9:25 am

Virus4762 wrote:
Sun Oct 06, 2019 11:16 pm
KyleAAA wrote:
Sun Oct 06, 2019 7:13 pm

I don't think lower valuation implies safety.

Although Atlassian is totally safer that Wix. Wix is a ness.
Well ya, I meant that if a company has a higher valuation based on just the numbers then one reason could be because it's a safer investment. I'm glad to hear you say that Atlassian is a safer investment than Wix because that's likely the explanation for the valuation difference. How is Wix a mess? Would you mind telling me what metrics you're referring to? I'm curious what it is I'm missing on their financials.
I'm referring to their technology.

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Re: I don’t understand the valuation of some companies – what am I missing?

Post by Virus4762 » Mon Oct 07, 2019 9:53 pm

KyleAAA wrote:
Mon Oct 07, 2019 9:25 am
Virus4762 wrote:
Sun Oct 06, 2019 11:16 pm
KyleAAA wrote:
Sun Oct 06, 2019 7:13 pm

I don't think lower valuation implies safety.

Although Atlassian is totally safer that Wix. Wix is a ness.
Well ya, I meant that if a company has a higher valuation based on just the numbers then one reason could be because it's a safer investment. I'm glad to hear you say that Atlassian is a safer investment than Wix because that's likely the explanation for the valuation difference. How is Wix a mess? Would you mind telling me what metrics you're referring to? I'm curious what it is I'm missing on their financials.
I'm referring to their technology.
I don't understand. How is their technology a mess? I mean, I know what they do, but how is it a mess?

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Re: I don’t understand the valuation of some companies – what am I missing?

Post by bhsince87 » Mon Oct 07, 2019 10:25 pm

"The market can remain irrational longer than you can remain solvent."
"If ye love wealth better than liberty, the tranquility of servitude better than the animating contest of freedom, go home from us in peace." Samuel Adams

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Re: I don’t understand the valuation of some companies – what am I missing?

Post by KyleAAA » Tue Oct 08, 2019 12:06 pm

Virus4762 wrote:
Mon Oct 07, 2019 9:53 pm
KyleAAA wrote:
Mon Oct 07, 2019 9:25 am
Virus4762 wrote:
Sun Oct 06, 2019 11:16 pm
KyleAAA wrote:
Sun Oct 06, 2019 7:13 pm

I don't think lower valuation implies safety.

Although Atlassian is totally safer that Wix. Wix is a ness.
Well ya, I meant that if a company has a higher valuation based on just the numbers then one reason could be because it's a safer investment. I'm glad to hear you say that Atlassian is a safer investment than Wix because that's likely the explanation for the valuation difference. How is Wix a mess? Would you mind telling me what metrics you're referring to? I'm curious what it is I'm missing on their financials.
I'm referring to their technology.
I don't understand. How is their technology a mess? I mean, I know what they do, but how is it a mess?
Their underlying technology, not the product.

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Re: I don’t understand the valuation of some companies – what am I missing?

Post by Scooter57 » Tue Oct 08, 2019 5:19 pm

nedsaid wrote:
Sun Oct 06, 2019 3:53 pm
Scooter57 wrote:
Sun Oct 06, 2019 3:48 pm
With stocks linked together in a great number of ETFs organized by sector, metrics, and a wide range of other at times obscure ways of arranging them, the price of individual stocks can rise and fall with little relation to the actual performance of the company. The proliferation of ETFs since the Financial Crisis has changed the way that stocks perform.
We have had vehicles like open ended and close ended mutual funds for a long time, they go back to the 1920's and Investment Trusts before then. How have ETFs changed trading patterns that mutual funds did not? Also, there have always been speculators that make bets in the market that aren't transparent to other market participants. My guess is that the proliferation of ETFs have helped drive up trading volumes but not sure they have changed the actual behavior of the markets.
The majority of mutual funds until very recently were stock picking funds, where fund management attempted to beat some benchmark by picking stocks to achieve some stated objective. There were few index funds outside of Vanguard and most of them were very broad market ETFs like SPY. So the individual stocks joined or exited funds because some human brain somewhere looked at the company's performance and decided if it looked like a good bet or not.

But people are not carefully evaluating the performance of the stocks that make up ETFs, and where in the early days ETFs followed indexes like the S&P indexes where individual companies were examined carefully before joining the index, with the proliferation of ETFs anyone can open one with an index criterion they define however they want. If a stock is in an index and that sector goes up that day, all the stocks in the index will get a boost. I have been observing a couple sectors out of curiosity for some years and see this happening consistently. Only if a company's stock is removed from the indexes it was in (for dropping below a certain market cap, for instance) and gets booted, does its price start fluctuating more based on company performance.

ETFs really have exploded and become a far, far greater proportion of all market trading than they were even a decade ago. Here's a telling set of statistics from the 2017 Investment Company Factbook which you can find at https://ici.org/pdf/2017_factbook.pdf. (Page 9). In 2007 before the last market meltdown there were 12,000 mutual funds and 608 ETFs. In 2016 there were 16,344 mutual funds and 2,524 ETFs. Bloomberg reported a year ago that Hedge Funds, Insurers, and Pension Funds were increasingly investing in ETFs because of the ease and low fees, (How ETFs Became the Market, Sept 13, 2018) and their ability to jump in and out in response to news. That article stated that on some days, especially when there is big news, ETF trading can rise to as much as 40% of all market activity.

Clearly this decouples the performance of the businesses issuing the stock bought by the ETFs from the pricing of individual stocks in the ETF.

There has also been a lot of discussion about how index fund companies, like Vanguard, do not vote the shares of the companies they own in ways that individual stockholders might, and that they rubber stamp executive-friendly measures that contribute to the obscene salaries and options execs award themselves. ETF-held shares run into the same problem. In theory, companies and their boards have to be answerable to shareholders, but when so many shares are owned by index funds and ETFs holding hundreds or thousands of company's shares that are traded hourly, the momentary owners of the shares--the gamblers who use them as chips--have in interest in the governance of the underlying companies. So the people running companies are given a license to enrich themselves at shareholders' expense, gut the companies, destroy their profitability through financial engineering that lets loans be used for manipuations like buybacks rather than innovations, new products, and growth. And that is exactly what is happening.

No one knows what is going to happen with the huge volume of shares traded via ETFs during the next market conniption. The Great Recession was pretty unusual, being as it derived from (self-caused) problems in the investment banking industry. The last time we had a recession based on company performance--in 2001--there were only 83 ETFs. Indexed funds were still a small proportion of the market, with active funds dominating the fund market. With those 2524 ETFs, many based on very strange indexes, leverage, and who knows what else, this time things are indeed different.

As we have learned time and time again, the big stock market debacles have a funny way of stemming from the brilliant new ideas that Wall Street comes up with during the boom times. Buying on margin in the '20s. The Nifty Fifty in the 1970s, Portfolio Insurance in the 1980s. Dot coms in the 1990s, and exotic derivatives and bundled loans in the 2000s. ETFs and the domination of index investing is what is hailed as the new Best Thing now. We will find out, eventually what their weaknesses are, but we can already see that one huge weakness is that they decouple price discovery from the performance and value of individual stock-issuing companies.

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nedsaid
Posts: 12618
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Re: I don’t understand the valuation of some companies – what am I missing?

Post by nedsaid » Tue Oct 08, 2019 10:11 pm

Scooter57 wrote:
Tue Oct 08, 2019 5:19 pm
nedsaid wrote:
Sun Oct 06, 2019 3:53 pm
Scooter57 wrote:
Sun Oct 06, 2019 3:48 pm
With stocks linked together in a great number of ETFs organized by sector, metrics, and a wide range of other at times obscure ways of arranging them, the price of individual stocks can rise and fall with little relation to the actual performance of the company. The proliferation of ETFs since the Financial Crisis has changed the way that stocks perform.
We have had vehicles like open ended and close ended mutual funds for a long time, they go back to the 1920's and Investment Trusts before then. How have ETFs changed trading patterns that mutual funds did not? Also, there have always been speculators that make bets in the market that aren't transparent to other market participants. My guess is that the proliferation of ETFs have helped drive up trading volumes but not sure they have changed the actual behavior of the markets.
The majority of mutual funds until very recently were stock picking funds, where fund management attempted to beat some benchmark by picking stocks to achieve some stated objective. There were few index funds outside of Vanguard and most of them were very broad market ETFs like SPY. So the individual stocks joined or exited funds because some human brain somewhere looked at the company's performance and decided if it looked like a good bet or not.

But people are not carefully evaluating the performance of the stocks that make up ETFs, and where in the early days ETFs followed indexes like the S&P indexes where individual companies were examined carefully before joining the index, with the proliferation of ETFs anyone can open one with an index criterion they define however they want. If a stock is in an index and that sector goes up that day, all the stocks in the index will get a boost. I have been observing a couple sectors out of curiosity for some years and see this happening consistently. Only if a company's stock is removed from the indexes it was in (for dropping below a certain market cap, for instance) and gets booted, does its price start fluctuating more based on company performance.

ETFs really have exploded and become a far, far greater proportion of all market trading than they were even a decade ago. Here's a telling set of statistics from the 2017 Investment Company Factbook which you can find at https://ici.org/pdf/2017_factbook.pdf. (Page 9). In 2007 before the last market meltdown there were 12,000 mutual funds and 608 ETFs. In 2016 there were 16,344 mutual funds and 2,524 ETFs. Bloomberg reported a year ago that Hedge Funds, Insurers, and Pension Funds were increasingly investing in ETFs because of the ease and low fees, (How ETFs Became the Market, Sept 13, 2018) and their ability to jump in and out in response to news. That article stated that on some days, especially when there is big news, ETF trading can rise to as much as 40% of all market activity.

Clearly this decouples the performance of the businesses issuing the stock bought by the ETFs from the pricing of individual stocks in the ETF.

There has also been a lot of discussion about how index fund companies, like Vanguard, do not vote the shares of the companies they own in ways that individual stockholders might, and that they rubber stamp executive-friendly measures that contribute to the obscene salaries and options execs award themselves. ETF-held shares run into the same problem. In theory, companies and their boards have to be answerable to shareholders, but when so many shares are owned by index funds and ETFs holding hundreds or thousands of company's shares that are traded hourly, the momentary owners of the shares--the gamblers who use them as chips--have in interest in the governance of the underlying companies. So the people running companies are given a license to enrich themselves at shareholders' expense, gut the companies, destroy their profitability through financial engineering that lets loans be used for manipuations like buybacks rather than innovations, new products, and growth. And that is exactly what is happening.

No one knows what is going to happen with the huge volume of shares traded via ETFs during the next market conniption. The Great Recession was pretty unusual, being as it derived from (self-caused) problems in the investment banking industry. The last time we had a recession based on company performance--in 2001--there were only 83 ETFs. Indexed funds were still a small proportion of the market, with active funds dominating the fund market. With those 2524 ETFs, many based on very strange indexes, leverage, and who knows what else, this time things are indeed different.

As we have learned time and time again, the big stock market debacles have a funny way of stemming from the brilliant new ideas that Wall Street comes up with during the boom times. Buying on margin in the '20s. The Nifty Fifty in the 1970s, Portfolio Insurance in the 1980s. Dot coms in the 1990s, and exotic derivatives and bundled loans in the 2000s. ETFs and the domination of index investing is what is hailed as the new Best Thing now. We will find out, eventually what their weaknesses are, but we can already see that one huge weakness is that they decouple price discovery from the performance and value of individual stock-issuing companies.
Not sure how stocks being held by ETFs will react any differently than stocks held by Index Funds, more passive factor funds, or by active managed funds. What has changed in recent years is that entire indexes trade on the exchanges in ETF form, lots of trading needed to keep the ETFs themselves very near the Net Asset Value of the underlying stocks. Hard to say exactly how ETFs would fare in a mass exodus, everyone trying to sell their ETFs at the same time, but this is a problem that all mutual funds face. The crowd hitting the exits at the same time could cause unique problems for ETFs that no one has thought of but after the panic subsides things return to normal. The S&P 500 SPDRs have traded for many years and so far no problem, it isn't like these things are brand new.

As far as price discovery, there are plenty of professional traders and hedge funds trading in individual stocks to keep the markets efficient. Also active fund managers look for pricing inefficiencies. The ETF structure might increase volatility of stocks in a panic but this effect would be temporary. The evidence seems to be that the markets are continuing to become even more efficient even as a higher and higher percentage of assets are passively managed.

Not sure about the unique risks posed by the structure of ETFs, so far so good.
A fool and his money are good for business.

Topic Author
Virus4762
Posts: 113
Joined: Fri Jul 13, 2012 10:53 am

Re: I don’t understand the valuation of some companies – what am I missing?

Post by Virus4762 » Tue Oct 08, 2019 10:12 pm

KyleAAA wrote:
Tue Oct 08, 2019 12:06 pm
Virus4762 wrote:
Mon Oct 07, 2019 9:53 pm
KyleAAA wrote:
Mon Oct 07, 2019 9:25 am
Virus4762 wrote:
Sun Oct 06, 2019 11:16 pm
KyleAAA wrote:
Sun Oct 06, 2019 7:13 pm

I don't think lower valuation implies safety.

Although Atlassian is totally safer that Wix. Wix is a ness.
Well ya, I meant that if a company has a higher valuation based on just the numbers then one reason could be because it's a safer investment. I'm glad to hear you say that Atlassian is a safer investment than Wix because that's likely the explanation for the valuation difference. How is Wix a mess? Would you mind telling me what metrics you're referring to? I'm curious what it is I'm missing on their financials.
I'm referring to their technology.
I don't understand. How is their technology a mess? I mean, I know what they do, but how is it a mess?
Their underlying technology, not the product.
Offering web development?

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