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discounting

I’m going to write about this topic in two posts.  Today’s will cover the basic idea.  Tomorrow, assuming Hurricane Sandy has left the cable and electric power lines alone, I’ll apply them to the current situation in world equity markets.

Here goes:

“Discounting” is a piece of Wall Street jargon.  It refers to the process in which investors factor into current stock prices their expectations about future events. It’s also used to describe the degree to which this process is complete.

Although most pople don’t think about it that much, the stock market is in many ways a futures market.  For example:

Based on trailing twelve months’ earnings, AMZN trades at a PE multiple of more than 3000x.  That’s over 200 times the PE of the average US-listed stock, which is trading at about 14x.  True, to some degree this is because AMZN uses extremely conservative accounting principles.  But it’s mostly because buyers are basing their purchase decisions on strong positive beliefs about AMZN’s future growth prospects.

In contrast, Seagate Technology (STX) is currently trading at 3.4x eps, implying that investors don’t hold high expectations for its future profits.  If we look at current earnings as a percentage of the current purchase price, a buyer is earning at a current rate of almost 30% of cost per year.  I don’t want to get into valuation metrics in this post but, believe me, but 30% is a lot, if you expect the current earnings level to be sustained or increase.

a qualitative term

Discounting isn’t a quantitative term.  It’s an expression of judgment.  I think the AMZN price is crazy high.  I’d express my reaction a bit more elegantly by saying that I think the AMZN quote already discounts much more profit growth than I can see the company ever achieving.

My impression isn’t worth very much, however.  I haven’t done any careful analysis of the company for years.  It may be that other researchers have, say, recast AMZN’s financials into a more conventional format that shows the PE multiple to be much, much lower than 3000.  The same people may also be envisioning a very sharp growth trajectory for earnings over the next five-ten years–and have a reasonable basis for doing so.  Such researchers would likely  express their judgment by saying that the market has not yet fully discounted AMZN’s prospects.

two forms

Discounting has two general forms:

–macroeconomic, where investors take conclusions about the overall economic environment and use them to draw inferences about the profit prospects for stock market sectors, industries and individual stocks, and

–microeconomic, where investors base their conclusions principally on their analysis of the individual companies they are focused on without much regard for the macro environment, other than as a mild head- or tailwind.

For very mature companies, which are so large that their growth can’t be much different from that of nominal GDP in the areas where they operate, investors typically use a blend of both forms.

For what it’s worth, Americans typically favor a bottom-up micro style for almost everything; Europeans typically prefer a top-down macro style.

two stages

Discounting begins to happen far in advance of facts.  Call this sort of discounting anticipatory.  It can be most easily seen in turns in the business cycle.  Wold stock markets bottomed in March 2009.  World economies reached their nadirs about six months later.

AAPL shares bottomed in relative performance terms in early 2005 at a price of about $40 (Note from April 2015:  this price is adjusted for the stock’s 2/1 split in February 2012, but not for the 7/1 split in 2014)..  During that year it traded at about 30x earnings, or about twice the market multiple.  I remember that one of my then colleagues would visit my office daily urging me to sell, on the argument that every possible future favorable event was already discounted in the price.

In reality, the opposite was happening.  The market was beginning to sense the changes that were occurring in the firm and were bidding up the stock as a result.  It’s up over 17x since.

A second kind of discounting, call it adjusting, happens when an event where opinions about possible outcomes have already been factored into a stock’s price actually occurs.

What follows is a period of recalibration, as expectations are adjusted in light of new facts.  If the actual results are surprisingly good–that is, better than have been already discounted–the stock typically quickly goes up.  If the results are surprisingly bad, the stock typically drops over the following few days–and then usually continues to drift downward over the following weeks and months.

The existence of two stages of discounting is what leads to Wall Street’s Yogi Berra-esque belief that “nothing’s ever fully discounted until the event occurs.”

Tomorrow (Hurricane Sandy willing):  using these ideas to assess the current stock market situation.