All these crazy valuations at IPO lately...

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Lemur
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All these crazy valuations at IPO lately...

Post by Lemur » Wed Jun 19, 2019 9:06 am

Has me thinking about the difference between investing & speculating. I'm just copying/pasting something I found on Reddit but I think this is from one of Buffet's annual shareholder reports:

I am also curious if Buffet actually uses the 10 year bond rate which is historically pretty low (correct me if I'm wrong) or if he utilizes a more realistic interest rate such as 6%.

Also as I have been on the index fund train for a few years now, I am trying to get myself back to the basics a bit. Having fun doing some manual DCF analysis...
Leaving aside tax factors, the formula we use for evaluating stocks and businesses is identical. Indeed, the formula for valuing all assets that are purchased for financial gain has been unchanged since it was first laid out by a very smart man in about 600 B.C. (though he wasn’t smart enough to know it was 600 B.C.).

The oracle was Aesop and his enduring, though somewhat incomplete, investment insight was "a bird in the hand is worth two in the bush." To flesh out this principle, you must answer only three questions. How certain are you that there are indeed birds in the bush? When will they emerge and how many will there be? What is the risk-free interest rate (which we consider to be the yield on long-term U.S. bonds)? If you can answer these three questions, you will know the maximum value of the bush -- and the maximum number of the birds you now possess that should be offered for it. And, of course, don’t literally think birds. Think dollars.

Aesop’s investment axiom, thus expanded and converted into dollars, is immutable. It applies to outlays for farms, oil royalties, bonds, stocks, lottery tickets, and manufacturing plants. And neither the advent of the steam engine, the harnessing of electricity nor the creation of the automobile changed the formula one iota -- nor will the Internet. Just insert the correct numbers, and you can rank the attractiveness of all possible uses of capital throughout the universe.

Common yardsticks such as dividend yield, the ratio of price to earnings or to book value, and even growth rates have nothing to do with valuation except to the extent they provide clues to the amount and timing of cash flows into and from the business. Indeed, growth can destroy value if it requires cash inputs in the early years of a project or enterprise that exceed the discounted value of the cash that those assets will generate in later years. Market commentators and investment managers who glibly refer to "growth" and "value" styles as contrasting approaches to investment are displaying their ignorance, not their sophistication. Growth is simply a component -- usually a plus, sometimes a minus -- in the value equation.

Alas, though Aesop’s proposition and the third variable -- that is, interest rates -- are simple, plugging in numbers for the other two variables is a difficult task. Using precise numbers is, in fact, foolish; working with a range of possibilities is the better approach.

Usually, the range must be so wide that no useful conclusion can be reached. Occasionally, though, even very conservative estimates about the future emergence of birds reveal that the price quoted is startlingly low in relation to value. (Let’s call this phenomenon the IBT -- Inefficient Bush Theory.) To be sure, an investor needs some general understanding of business economics as well as the ability to think independently to reach a well-founded positive conclusion. But the investor does not need brilliance nor blinding insights.

At the other extreme, there are many times when the most brilliant of investors can’t muster a conviction about the birds to emerge, not even when a very broad range of estimates is employed. This kind of uncertainty frequently occurs when new businesses and rapidly changing industries are under examination. In cases of this sort, any capital commitment must be labeled speculative.

Now, speculation -- in which the focus is not on what an asset will produce but rather on what the next fellow will pay for it -- is neither illegal, immoral nor un-American. But it is not a game in which Charlie and I wish to play. We bring nothing to the party, so why should we expect to take anything home?

The line separating investment and speculation, which is never bright and clear, becomes blurred still further when most market participants have recently enjoyed triumphs. Nothing sedates rationality like large doses of effortless money. After a heady experience of that kind, normally sensible people drift into behavior akin to that of Cinderella at the ball. They know that overstaying the festivities -- that is, continuing to speculate in companies that have gigantic valuations relative to the cash they are likely to generate in the future -- will eventually bring on pumpkins and mice. But they nevertheless hate to miss a single minute of what is one helluva party. Therefore, the giddy participants all plan to leave just seconds before midnight. There’s a problem, though: They are dancing in a room in which the clocks have no hands.

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Dream of Freedom
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Re: All these crazy valuations at IPO lately...

Post by Dream of Freedom » Wed Jun 19, 2019 11:11 am

Well, from a larger point of view, ipo speculation helps society in the same way evolution helps your species.. The companies are funded by speculators. The weak companies die off. The strong expand, serve costumers, develop technology and hopefully pay the speculators for the trouble.

To get into the weeds a bit more, there is a lot to consider there. Stocks as a whole have asymmetric risk, meaning they cannot go below zero but could double or triple. IPOs tend to be fast growing which maximizes the effect as the potential upside gets farther from the downside. They are also raising money which allows them to grow faster. Of course with more capital they can borrow more, whichever you guessed it allows it to grow faster still.

Now for the downside. They are hard to evaluate. You can't use technical analysis because they have no trading history. If the company is newly formed you won't be able to do much fundamental analysis because they have no earnings history. And even when the company has been in business for a while you might have more to work with, but the additional funds may transform the company. Who knows what you're going to get?

Nomad
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Re: All these crazy valuations at IPO lately...

Post by Nomad » Wed Jun 19, 2019 1:11 pm

I for one totally avoid IPO's, I go with funds and preferably ones with 5 - 10-year histories...

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Lemur
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Re: All these crazy valuations at IPO lately...

Post by Lemur » Wed Jun 19, 2019 3:25 pm

@Dream of Freedom

I enjoyed reading this perspective. Slack Technologies has its IPO tomorrow and its the company I'm keeping my eye on. Supposedly coming out at $28 a share but ...fair valuation based on known information prices it at $5 for a realistic scenario.

@Nomad

Mostly agree...the smaller gambler inside of me fascinates about the possibility of doubling my money in a click of a button and that doubling of money would have equaled 2 years of working and saving for it. Something very enticing about that.

Nomad
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Re: All these crazy valuations at IPO lately...

Post by Nomad » Wed Jun 19, 2019 7:08 pm

@Lemur
Yes, that is the thrill of gambling. I have traded individual company stocks in the past and it can be quite fun. One contrarian tactic that often works is
to buy a stock that has had some 'bad news' and the share price has taken a tumble. Usually in these circumstances the stock market completely
overreacts, so if you are prepared to buy and wait a few weeks for recovery you can make 20-30% gains quite easily. However, this is a white
knuckle ride.

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Lemur
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Re: All these crazy valuations at IPO lately...

Post by Lemur » Wed Jun 19, 2019 7:44 pm

Nomad wrote:
Wed Jun 19, 2019 7:08 pm
@Lemur
Yes, that is the thrill of gambling. I have traded individual company stocks in the past and it can be quite fun. One contrarian tactic that often works is
to buy a stock that has had some 'bad news' and the share price has taken a tumble. Usually in these circumstances the stock market completely
overreacts, so if you are prepared to buy and wait a few weeks for recovery you can make 20-30% gains quite easily. However, this is a white
knuckle ride.
I'm thinking of National Beverage Corporation (FIZZ) when it comes to that but the problem here is that the over-reaction actually just brought it down to a fair value imo.

Nomad
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Re: All these crazy valuations at IPO lately...

Post by Nomad » Thu Jun 20, 2019 12:51 am

Lemur wrote:
Wed Jun 19, 2019 7:44 pm
I'm thinking of National Beverage Corporation (FIZZ) when it comes to that but the problem here is that the over-reaction actually just brought it down to a fair value imo.
The examples I would give are the drop in Volkswagon shares after the emissions scandal story broke or the price of house builders in the UK such as Persimmon Homes on the day after the Brexit referendum result.
Both essentially sound companies having a very bad stock market day.

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