Last week I talked about the two questions I’ve been hearing lately: “How bad will it get, and how long will it last?” This week, amid the continuing stock market tumult, some people are asking a third question: “Should I even bother investing in the stock market? It just seems crazy.”
It’s a fair question. On Monday, the market was up 4%. On Tuesday, it dropped 3%. On Wednesday, it was up 4% again. Then on Thursday and Friday, it was down again 3% both days.
You wouldn’t be alone in thinking the stock market is crazy. Warren Buffett calls the market “manic-depressive.” And Howard Marks, one of the clearest thinkers in the investment field, has observed that investor sentiment tends to oscillate between the extremes of “flawless” and “hopeless.”
With the market’s extreme behavior over the past few weeks, it’s hard to debate these characterizations. But is that it? Should we simply write off the market as crazy and unpredictable?
To answer this question, it’s worth taking a step back to look at the drivers of stock prices. As I see it, there are three:
1. Corporate profits, including expectations for future profits.
2. External events, including political and economic developments, and of course, health scares.
3. Investor sentiment.
From day to day, the share price of each individual company reflects some combination of these three factors. In recent weeks, however, there’s no question that #2 and #3 have been in the driver’s seat. The coronavirus is almost entirely responsible for the market’s drop. But over the long-term, it’s #1—corporate profits—that has the largest impact on stock prices.
If that’s the case—if corporate profits matter most over the long term—then how much should we really worry about the stock market? To put it another way, is the market’s recent drop warranted, or is this just the temporary, and irrational, result of wide-scale panic?
To answer this question, let’s look more closely at #1—the math behind stock prices. To illustrate how this is done, I’ll use a simple example: Procter & Gamble, the maker of Pampers, Ivory soap and other household products. Today, P&G is worth about $300 billion. The question we want to answer is: Would P&G still be worth that same $300 billion if the coronavirus brought the economy to a standstill?
The textbook method for valuing a stock is known as discounted cash flow (DCF). To do this, one simply totals up all of a company’s estimated future profits, the idea being that a company should be worth the sum total of all the profits it could produce over its lifetime. DCF analysis then applies a “discount” to each future year’s profits based on the principle that a dollar next year is worth less than a dollar this year.
Last year, P&G’s profits were about $10 billion. If we make some basic assumptions about future growth, we can calculate the total value of P&G using this method to be about $300 billion. So that, mathematically, explains the current stock price.
Now we can answer the earlier question: What would happen to stock prices if the health situation got worse—if everyone were quarantined and the economy ground to a halt for the rest of the year? The math here is fairly easy. If P&G’s future profits add up to $300 billion, and we remove one year of profits—assuming they earn nothing this year—then the company should be worth $10 billion less. And while $10 billion is a big number, it represents just 3% of P&G’s total value. In other words, according to the numbers, even in an extreme scenario, the company’s value should really drop by only 3%.
If the economy did slow materially as a result of the virus, then some companies would be affected more than others, but the general idea is this: The stock market value of any company represents all of its future potential profits, so any short-term losses usually represent just a small fraction of its overall worth.
I fully acknowledge that at times like this, most investors aren’t sitting down doing DCF analysis. For now, sentiment has taken over. But this math does explain my “don’t panic” view of the situation. No question, this is all very unnerving—and things could get worse before they get better—but I wouldn’t get caught up in the panic. I wouldn’t sell out of stocks, and I wouldn’t fear that this will cause lasting, long-term or irreparable damage to stock market investments. Yes, the market does go to extremes in the short term. But over the longer term, I believe that rationality will prevail.