Discounts

The allure of getting a bargain is universal. Everybody loves a discount. Even when investing in stocks or bonds, you’d love to buy at a discount. The problem is that the discounts in financial markets are much less obvious than in the grocery store.

The value of any financial asset can be estimated by calculating the present value of all the future cash flows. Mathematically, this is a straighforward calculation. The difficult part is estimating the future cash flows and the appropriate discount rate to calculate the value in today’s dollars (the present value).

If you had the choice of being given $100 today, or $100 in ten years, you’d clearly take the $100 today because in ten years, that $100 bill is going to buy a lot less stuff than it will today. We’ve recently witnessed that first hand because $100 buys a lot less now than it did before the pandemic fueled inflation. When financial analysts calculate ‘present value’ they attempt to adjust for this embedded inflation. For example, if we are experiencing 5% annual inflation, the present value of $100 a year from now is $95. In other words, $95 today is equivalent to $100 a year from now. Of course, it is not easy to estimate the effect of inflation over a long time frame, so that is one point of complication in valuing a stock (or a bond, for that matter).

The second point of complication is estimating what the future cash flows of a company will be. As a share owner, you own a pro rata ownership in a company and therefore a claim on the cash flow the company produces. Of course, you can’t declare dividends for yourself, but companies that produce more stable cash flows are easier to estimate than others and therefore easier to estimate value. But if you knew the appropriate discount rate that would compensate you for the risk to the value of money over time (inflation) and you knew the cash flows that a company could produce, calculating a reasonable value is not difficult.

Why Bring This Up?

The reason is that the FOMO (fear of missing out) around NVIDIA and other AI driven companies is overwhelming. The stocks seem to keep rising no matter what happens. NVIDIA stock may be down this week, but a Barron’s advises that the stock is going to move higher. Conclusion? BUY NVIDIA!

We’re not making any attempt to call a top to this trend, but we realize that when markets get hyper-focused on the present and assume an extremely rosy future, the market trades much more on emotion, and much less on rational thought. This movie has been played over and over again throughout history.

We suggest reading the first hundred pages or so of Extraordinary Popular Delusions and the Madness of Crowds, written by John McKay in 1841, which describes several bubbles from centuries ago, including Tulip Mania in the 1630’s, when the price of a single, rare tulip exceeded the annual income of a skilled worker at the time. When prices rush higher and emotions overcome rational thought, there is no telling how high the price will go. Humans appear particularly adept at extrapolating the present forever. What we can say with confidence is that at some point, prices will become rational again.

A Valuation Exercise

We utilized gurufocus.com to take a look at a reverse discounted cash flow (DCF). Don’t be intimidated by the name. A reverse DCF simply looks at the growth and discount rate necessary to solve for the current price. By looking at the problem this way, we can more easily see how rational, or irrational, the current price may be.

We used this exercise (and we need to emphasize that the following is NOT an analysis) to perform a quick ‘pressure test’ on NVIDIA, the current AI darling, and most valuable company on earth as this is written. The goal is to see what might be ‘baked into’ the current price. We need to emphasize that this is NOT a detailed analysis, it is merely an exercise to add some insight on valuation.

We used gurufocus.com to do the mathematical heavy lifting for us. In the model below we have adjusted NVIDIA’s growth rate to 30% for the next ten years, and 5% for the following 20 years (red boxes). We have also plugged in a discount rate, or the required rate of return, of 12% because we’d expect a return in excess of the historical market returns. Using these assumptions yields a fair value for NVIDIA of $127.56, which is very close to the current price. The implication is that if the growth is as expected, you should expect a 12% annualized return.

What to do?

We have little doubt that AI will be a transformative technological advance, much like the internet was 25 years ago, or automobiles were in the early 20th century. However, that does not imply that you can buy AI stocks with impunity any more than you could buy internet stocks or auto stocks with impunity when they were the disruptive technologies.

There is no obvious need to sell anything immediately. There is nothing that prevents NVIDIA and other AI leaders from going even higher, but we’d be remiss if we did not counsel some profit taking. This is one of those times when keeping up with the benchmark S&P 500 index is not necessarily a rational goal. The only way to keep pace with the index today is to buy into the frenzy.

 

The chart above, which we picked from X (formerly twitter), shows the weight of the top ten S&P stocks as a percent of the total S&P 500 at a recent new high of 37.5%. The spike from 2022 to present is almost exclusively due to the impact of AI on valuations. It requires some industrial-sized weights of these AI stocks in a portfolio just to keep pace with the index. What this chart makes clear is:

1) Emotions can drive stock prices to irrational highs and it is not possible to gauge where it will end.

2) Eventually, reality kicks in and there is some ‘reversion to the mean’, that is, a meaningful correction occurs.

Proceed with caution, because when this corrects, the other 490 stocks will be outperforming the current top ten.

 

Summer Solstice

The summer solstice is now behind us and the days are again getting shorter. Enjoy the summer while it lasts! Have a great week!

 

What We’re Reading

AI boom is masking underlying weakness

It’s too early to get negative on semiconductor trade

Biden, Trump prep for presidential debate that will highlight mental fitness

 

Palumbo Wealth Management (PWM) is a registered investment advisor. Advisory services are only offered to clients or prospective clients where PWM and its representatives are properly licensed or exempt from licensure. For additional information, please visit our website at www.palumbowm.com.

The information provided is for educational and informational purposes only and does not constitute investment advice and it should not be relied on as such. It should not be considered a solicitation to buy or an offer to sell a security. It does not take into account any investor’s particular investment objectives, strategies, tax status or investment horizon. You should consult your attorney or tax advisor.

The views expressed in this commentary are subject to change based on market and other conditions. These documents may contain certain statements that may be deemed forwardlooking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected. Any projections, market outlooks, or estimates are based upon certain assumptions and should not be construed as indicative of actual events that will occur.

All information has been obtained from sources believed to be reliable, but its accuracy is not guaranteed. There is no representation or warranty as to the current accuracy, reliability or completeness of, nor liability for, decisions based on such information and it should not be relied on as such.

 

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By: Adam