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What’s Medibank really worth?

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.

Foolish takeaway

When a stock goes up or down, even by a few percentage points, there's a tendency to think the market is trying to tell you something. That it's signalling your company is worth less, or more, than it was a day ago, or a few weeks ago.

But that's rarely the case.

The majority of stock movements are just random wobbles within a reasonable valuation range. Medibank shares jumping from $2.00 (or $2.15 if you were an institutional buyer) to $2.20 might not mean anything at all. It might just mean that shares are probably worth something between $1.80 and $2.30, and anything within that range means more or less the same thing.

"But nobody thinks about markets that way," Salmon said. "Although they should."

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Morgan Housel is a Motley Fool columnist. You can follow The Motley Fool on Twitter @TheMotleyFoolAu. The Motley Fool's purpose is to educate, amuse and enrich investors. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.

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