Wednesday, August 25, 2010

An effort towards frequency

As many of you are aware, disruptive change has been a constant in my life since this blog was born. Before I conceived of putting this blog together, I wanted to make a committment to post comments to it on a regular basis, in accordance with my own experience reading other people's blogs. I have failed by every objective measure of consistency thus far.

To stand out, I have tried to write things that are meaningful to me, and to fortify my assertions with historical precedent. While it may not seem obvious to my readers, I have expended a considerable amount of time and research to create my prior posts. To provide more consistency in my entries, I have come to the conclusion that I will have to sacrifice my relatively long and deliberative entries. I am not abandoning them entirely. I am hoping that they will be as frequent as they have been up to this time, but I intend to make more frequent but shorter entries that address the world in which I am immersed--ecnonomics, business and finance.

I am going to comment on business news from the perspective of an institutional investor, which is what I have been for over a dozen years. Many people do not understand the movement of the markets, and many times the moves in stock prices seem counter-intuitive to outside observers. It is my intent from now on to basically relay to you how a particular current event affects the world of business and finance and how institutional investors would try to position themselves to profit from it.

As an introduction, let me introduce you to the mathematical formula that simply portrays how every institutional investor thinks.

Stock price (S)=  Cash flow year 1 +  Cash flow year 2 +....Cash flow year N
                            (1+WACC)             (1+WACC)              (WACC- growth rate)

WACC= weighted average cost of capital.

To boil it down, theoretically the price of a stock is the sum of all investors' perceptions of its future cash flows discounted back at the company's cost of acquiring capital. All investors are trying to predict the future profitability of the company. What many people understand only implicitly is that a company can make a great deal of money and still drive its stock price into the ground. That is done most times by management's underappreciation for the company's cost of capital (i.e. they underestimated how much the capital they have costs).

The conventional case of driving a stock price into the ground is when management turns a money-making business into a money losing business.

Going forward, I intend to discuss the 2 or 3 major news items of the week in terms of how an institutional investor would respond to them and why. Generally speaking, every news item you can think of either has a marginal impact on the future cash generating ability of a given enterprise, or it has an impact on its cost of obtaining capital or both. I will try to break it down for you, so that you can better understand the motivations of various business actors and their constituencies. Contrary to what you might think, all things business are not driven by  rapacious money-mongers, though they do exist.

Stay tuned.

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