I’m taking a Financial Management class1. Right now we’re studying net present value (NPV)—a formula to estimate the present value of future cash flows—and making capital investment decisions. It’s finance-y and pretty technical, but if you spend the time plugging things into a spreadsheet, it eventually makes sense. “This is a thing I could imagine using in my everyday role at work” is a thought that has gone through my head.
But am I going to use it? I dunno. Tech companies can be weird. Look at Qualtrics, for example. In their most recent annual report2, they reported losses of $37M, $1B, and $273M in the years 2018, 2019, and 2020, respectively. That’s cash that flowed out during the last three years. No profit. Qualtrics’ market cap on March 10 was $19 billion.34
But Qualtrics looks downright normal compared what else is going on out there.
Present value of expected future cash flows
From a recent Matt Levine Money Stuff column, the section titled Everything is Super Weird, commenting on GameStop stock:
I feel like 100 years ago a stock would go up and you’d be like “why” and the answer would be “the people who buy stocks like this stock so they bought it and it went up,” and that was, if not an entirely illuminating explanation, at least the best you were gonna get. And then people invented fundamental analysis and discounted-cash-flow valuation, and companies started disclosing detailed financial information, and stock investing became professionalized, and the importance of institutional investors grew as the influence of individual investors waned, and individuals started investing through funds and eventually index funds and left stock trading to be a highly competitive business done by financial professionals. And it became fashionable to say things like “the price of a stock reflects the present value of its expected future cash flows,” and if a stock went up and you asked why and someone replied “well people decided to buy it” you would think they were being annoying. And then retail trading became free and the pandemic happened and everyone’s brains broke and now GameStop goes up 28% in a day and you ask “why” and the answer is that it’s August and people like the stock. What are we all doing here.
That reference to fundamental analysis? That’s what we’re talking about when we talk about net present value. He’s referring to the famous securities book, Security Analysis, written by Benjamin Graham and David Dodd in 1934. This is the book that Warren Buffet calls "a road map for investing that I have now been following for 57 years." The book was written in 1934, shortly after the stock market crashed in 1929. The Securities Act of 1933 required companies to publish financial information (like Qualtrics’ or GameStop’s annual 10-k), so a book about fundamental analysis of those financial statements would have been rather timely and useful.
Stonks, are you drunk?
The Stock Market Fails a Breathalyzer. Where do I start? How about this:
AMC Entertainment’s stock was scraping $2 at the end of 2020. It is now $50 thanks in part to Robinhood speculators, and the company has smartly raised cash. But what about fundamentals? Theaters are still sparse, and Disney and others are willingly putting blockbusters directly onto their streaming services—ask Scarlett Johansson about Black Widow’s ticket sales. Theaters are the new roller rinks.
Or:
Startups these days raise money as “the Uber of gardening” or “Space as a Service.” Oh wait, the latter was WeWork’s pitch, whose founder Adam Neumann declared in 2017, “our valuation and size today are much more based on our energy and spirituality than it is on a multiple of revenue.” Is “spirituality” the S in SPAC?
Or:
So no, fundamentals don’t matter—well, until they do. In 1989 Tokyo real estate sold for as much as $139,000 a square foot—350 times the value in Manhattan. At that price, Tokyo’s Imperial Palace was worth more than all the real estate in California. Not anymore after Japan’s triptych of lost decades.
Or:
Today’s negative real yields don’t reflect reality. The Fed has warned it plans on tapering bond and mortgage purchases later this year. Someone is at least reaching for the punch bowl. The compass may stop spinning soon. Until then and always, stick with fundamentals.
I quoted nearly half the article. You might as well have read the whole thing.
“Traditional finance is a black box”
From the Wall Street Journal, The Social-Media Stars Who Move Markets.
“Traditional finance is a black box,” said Sarah Petite, a social-media consultant in Los Angeles. “This generation is looking at their parents and saying, ‘The way you thought about money? That isn’t how it works anymore.’ ”
Instead, young people want a road map to how to make big profits, and a strong independent streak draws many of them to online influencers who dole out advice free, rather than paying a traditional investment manager to handle their money for them. Many don’t care much about the qualifications of who’s giving the advice, experts and young investors themselves say.
“I have a rule: Don’t pay for something you can get free,” said Rex Wu, a 33-year-old investor from Tampa Bay, Fla., who is a regular viewer of [YouTube stock-market influencer and also somehow California gubernatorial candidate Kevin] Paffrath and several other online finance-world personalities. He says he has invested a few hundred thousand dollars based on “things I’ve learned online from guys like Kevin.” So far this year, his portfolio has returned 23%; year-to-date, the S&P 500 has returned 21%.
“If I were to walk into JPMorgan tomorrow, they have the bias of trying to earn my business, and they might be trying to oversell me,” Mr. Wu said. “Guys online don’t really have anything they’re trying to sell me.”
From earlier in the article, “Mr. Paffrath says he earned $5 million in the first three months of this year.” Yep, probably not trying to sell you anything.
Matt Levine’s take:
Look, the thing about “traditional finance is a black box” is that it actually comes with a fairly complete and well-understood explanatory structure. “Why is this stock worth $X? Because the present value of its expected future cash flows is $X. What does that mean? Well, here’s the Wikipedia page on discounted cash flow modeling, and here are six analyst reports projecting the company’s future cash flows, which are based on guidance from the company, and here is a spreadsheet with all of my inputs and assumptions.” Like it is a “black box” in the sense that, if you don’t want to bother with learning all of that stuff, you won’t understand it, but that is true of most things. And it is a “black box” in the related sense that there are professionals who will worry about it for you, so you don’t have to bother with learning all of that stuff. Also right yes of course that explanatory structure does not work especially well; stocks are regularly over- or under-valued compared to their actual future cash flows, and move around too much to be justified by changes in those expectations, and those professionals have a hard time beating the market. Still it is … there is a way to think about it, you know?
And then meme investing in 2021 is like “I have to be an astronaut and show them that the rocket ship is fun” and yes right in a sense all of this stuff is simple — “let’s all buy the same stock and then it will go up” — but … is it not a “black box”? Is it not totally resistant to understanding and analysis and explanation and meaning? Is it not just “this stock is going to $10,000 because that’s a very large number that is fun to say”? How did you calculate that number? Or am I just old? Anyway I don’t know what to tell you but I guess a lot of people on YouTube do.
What now?
Thinking about the current state of finance and the stock market can sometimes make my head spin. “When’s this all going to come crashing down? And what will happen when it does?” The future of the stock market is of course out of my control, so I try to focus on what I can control.
Cash flows have to come from somewhere—even if sometimes these days their importance is completely ignored—and that somewhere is from delivering a valuable product or service to a customer at a profit. It might be hard to predict if and when the music will stop in today’s markets. In the meantime, the best way to reliably predict cash flows tomorrow is to focus on effectively delivering value to customers today.
Qualtrics’ 10-k. Look at the income statement (“Consolidated Statements of Operations”) on page 81. Note the “Net loss” line item. That represents how much cash flowed out of the organization in those years. If you look at the cash flow statement on page 85, you’ll see the same three numbers on the top line.
I’m having trouble finding historical numbers for market cap, so I’m taking the current market cap of $24.306B, dividing my the current stock price of $47.23, which gives me the number of shares outstanding today. I’m then taking that number and multiplying it by $37.49, which is where Qualtrics closed on March 10, the day after they filed their 10-k.
Yes, I know that if you project far enough into the future, as long as the firm eventually is profitable (at a magnitude considerably greater than today’s losses), the math can work out to justify a considerable investment today. But still feels a little weird, yeah?
> the best way to reliably predict cash flows tomorrow is to focus on effectively delivering value to customers today.
That's the key!
Aside, but it really bugs me when the "wizened stock people" belittle the Gamestop thing as "for the lolz". They're either naively or willfully trying to ignore that there was an actual plan there, of squeezing the short. The value of the stock went up because the shorter had to buy it, not because of the memers.