Ugly blokes
Last reviewed July 2022
A few years ago I was bemused at the discovery that the portrait titled “Head of a Man” was not in fact painted by Van Gough, and instead perhaps by an unknown student of his era. The subsequent value of the portrait dropped from a reported figure of $20 million to a fraction of that amount.
I’m no art critic, but what I saw as a painting of an ugly bloke, still remained a painting of an ugly bloke, yet because a different person appears to have painted it, the value of the portrait is no longer supported.
To put in bluntly, the value of art work is generally determined by the “bigger fool than though” theory. Based on this theory, if you own a valuable piece of work, to make a profit from it, you must generally find a bigger fool than you who is willing to pay more money for it than you did.
And so it seems, over the past few months we have seen some companies listed on the stock exchange suffer a similar fate. These companies, which can only be classified as “ugly blokes” have suddenly been exposed for what they really are…..well, “ugly blokes”. Profits from speculative share trading rely on the “bigger fool than though” theory as much as art work does. This is because they often don’t generate real profits and therefore, calculating the true value of the company is difficult.
Generally, the value of an asset may be calculated by adding the Net Present Value of all future cash flows. It doesn’t matter what asset it is. It may be shares, property, bonds or a business. In making this calculation you must “discount” the future cash flows by a percentage. This percentage represents the opportunity cost of doing something else with your money, and also the risk that you are taking in making this investment. Therefore, the higher risk the investment, the greater the “discount rate” is.
Let’s take a simple example of a company that generates an expected profit of $10 per share (in perpetuity). Based on other opportunities and the risk of the investment you decide to discount that future cash flow by 15%. If you divide $10 by 15%, the value is $66. That is what you think a share in that company is worth.
These companies, which can only be classified as “ugly blokes” have suddenly been exposed for what they really are… well, “ugly blokes”. Profits from speculative share trading rely on the “bigger fool than though” theory as much as art work does.Now let’s look at that share value if circumstances change. Let’s say the dividends stay the same, but interest rates rise, and so you want higher compensation for the risk you take in buying listed companies, so you decide to discount the cash flows by 20% (not 15%). Divide $10 by 20% and the value of the share is now $50!!!
So investors may have noted the falling stock market lately and wondered why it is doing so when the underlying companies haven’t reduced their profits or dividends. The answer my friends, is simply investors are increasing their discount rate. As for the ugly blokes, when you know there is no one foolish enough to pay more than you did, you have to go back to the quality, not the perceived resale value.
Julian McLaren is an Authorised representative of Oreana Financial Services Pty Ltd, AFSL 482234. This advice may not be suitable to you because it contains general advice that has not been tailored to your personal circumstances. Please seek personal financial and tax/or legal advice prior to acting on this information. Past returns are not indicative of future returns
