Having poked holes in the "Castle In The Air" approach to investing, Malkiel now discusses the Firm Foundation approach. (Both of these approaches were introduced in Chapter 1.) The author discusses what he considers to be the four key determinants used to value stocks using the intrinsic value approach:
1) The expected growth rate
2) The expected dividend payout
3) The degree of risk
4) Market interest rates
Malkiel references or shows evidence that each of these factors do play a role in determining prices. At the same time, however, the willingness of investors to pay for each of these factors can change drastically in relatively short periods of time. For example, while the market always pays more for "growth" stocks, during bouts of market optimism (pessimism) the market is willing to pay a high (low) premium relative to the broad market.
Part of the reason for this fluctuation is that items like the future growth rate cannot be known for certain, and so expectations fluctuate wildly based on the market's overall sentiment. From the words of an analyst who tried to determine the intrinsic value of IBM a few decades ago:
"I began by forecasting growth in earnings per share. This was a little under the average for the previous ten years...I forecast at 16% growth rate for 10 years, followed by indefinite growth at 2%...When I put all these numbers into the formula, I got an intrinsic value of $172.94, about half of the current market value. It doesn't really seem sensible to predict only 10 years of above average growth for IBM, so I extended my 16% growth forecast to 20 years."
Despite the tendency to fall prey to biases/sentiment and the fact that the inputs are to the model are so uncertain, analysts/investors treat their estimates as being certain, and rely on precise calculations in forming their decisions. Unfortunately, when the inputs are so uncertain, precision can hardly be expected in the results.
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