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The Equitymaster Research Digest

Valuation Ignorance, Asad's Great Strategy, And More...
Oct 9, 2015

It is that time of the year when India Inc publishes its quarterly report card. It's the earnings season.

I've always wondered why results have to be synchronised with the amount of time it takes for earth to complete a fourth of its revolution around the sun. But that's a story for another day.

Today, we are discussing the impact of quarterly results on a company's share price.

I read an important insight a few years back that has remained with me ever since. It was about how most investors get valuations wrong. It was also about why it is a terrible idea to send the stock price of a fundamentally strong company to the doghouse after a few quarters of bad performance.

The truth about valuations

You see, the way valuations work, a huge bulk of the total value of a firm is back-ended. For a fundamentally strong firm that will be around for many years, and that pays out half its earnings in dividends and reinvests the other half, cash flows for the first 25 years account for only 50% of the firm's value! To put it differently, nearly 50% of a firm's intrinsic value comes from cash flows after the 25th year.

Here comes the more interesting point. Even if a firm's cash flows were to fall by 50% over the next five years, the total impact on the firm's value would be just 5%. This is because five years' worth of cash flows account for just around 10% of the firm's value. Even if the problem lasts for 10 years, the eroded value would be just 11-12%.

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