When you were a kid, do you remember wanting to do something and being questioned by your parent, “Why do you want to do that”? A child would almost always reply, “Because everyone else is”.
Those familiar with this life lesson also know the next part of the story where the parent replies, “if everyone was jumping off a bridge, would you want to also?”
Recently mutual and hedge funds are “chasing returns” in order to catch up to their benchmarks. This means funds are buying stocks for the sole purpose of being more fully invested in order to keep up with their benchmark returns.
Since benchmarks are the primary measuring stick used by investors to see how their managers and investments are doing, funds must unfortunately play this game. They must buy stocks, “because everyone else is”.
Fundamental analysts scour through earnings, revenues, financial statements and other company-specific data points to reach a conclusion as to what a stock’s price is worth. This all comes down to a company’s earnings and cash flows. But they also must come up with a company’s “multiple”. Applying the multiple to earnings is a popular way to come up with a “fair” price for a stock.
For the die-hard academic, the multiple is supposed to be some derivative of a company’s discount rate and weighted average cost of capital (NYSEARCA:JNK) by means of un-levering the Beta and/or use of other sophisticated financial models. What a mouth full!
This is rarely the case in the real world, though, as the sole use of cost of capital more often than not gives a much lower valuation for public companies (NYSEARCA: IVV) than is the reality in today’s markets.
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