On US talk show Charlie Rose last week, financial journalist Felix Salmon made a good point about market volatility:
"It is impossible to know the value of a company like Apple or Goldman Sachs to within a half a percent either way. But that's what you wind up doing when you look at the stock price. You say, 'Oh it went up a percent! Or down a percent!' That is pure noise in the distribution of roughly, more or less, where we think [the price] should be."
How true. And this is something that private companies handle better than public companies.
When a private company wants to know how much it is worth, management hires an investment bank, or a valuation consultant, which provides an opinion.
Analysts look at the company's financial statements, do some wizardry in Excel, and come up with a reasonable estimate for what the company is worth.
But when an investment bank presents a private business owner with a fairness opinion, you will almost never see this:
"We think your company is worth $18.16 per share."
Instead, you'll almost always see something like this:
"We think your company is worth between $17 and $19 per share."
Precisely, exactly wrong
Valuations are given in a range, not an exact value.
There's a good reason for this.
All valuation estimates are just that — estimates. They're an attempt to predict a future that, in reality, cannot be known.
To value a company, I have to know what future interest rates will be, for example. But I don't. And I can't.
I can, however, come up with a reasonable range of possibilities.
I can't look at you with a straight face and say 10-year US Treasuries (often used as a proxy for a 'risk free' return) will yield 4.21% in January 2017. But if I said there's a good chance 10-year Treasuries will yield somewhere between 3% and 5% in January 2017, that's more realistic. (The range could still be off, but it has a better chance of being more or less right.)
Same goes with earnings growth, capital spending, cost of goods sold, and dozens of other variables. The future is thought of in a range of probabilistic outcomes, so current valuations are presented in a range, too.
But the stock market doesn't.
The hares are off and running
As I write, your Medibank shares are trading for $2.20 a share. There's no range of possibilities — not "between $1.80 and $2.30 a share." The exact price, right now, is $2.20. That's what the market estimates Medibank's future cash flows are worth, discounted back to today – and probably topped with more than a little IPO hype.
But not even the market, which aggregates millions of opinions into a single price, can know exactly what the future holds. We can only make reasonable estimates about a range of outcomes.
The reality is that, even if Medibank (just to use an example) is priced at $2.20 a share, there's a range of prices that would be reasonable to pay.
It might be reasonable to pay $1.80 a share, or $2.30. Either probably makes sense given the range of potential future outcomes.
Thinking of values this way should change how you react to short-term volatility.