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C(ompletely) R(edundant) A(sset) P(ricing) Model PDF Print E-mail
I have a fundamental problem with the assumption that value today depends on the theoretical value tomorrow.

Through many repeated MGMT and OMIS courses, I have been made to believe that Excel can in fact, predict the future. “But professor, how do you know that sales are going to grow by 5% over the next quarter?” The short answer? She doesn’t.

After two years at business school, I don’t claim to be an expert on economic or financial forecasting. My experience is just a drop in the ocean when compared to what experts in the field have learned through years of trials, tribulation and observations. But still, I have a fundamental problem with the assumption that value today, depends on the theoretical value tomorrow. There are a few concepts we are all pretty much familiar with and now, I feel that it is my moral obligation to expose them for what they really are.

Sales forecasting: Regression or moving average, the fundamentals of these analyses are based on past data which, don’t get me wrong, may be a decent indicator of performance tomorrow. What happens if a meteor shoots out of the sky and hits your store? Daily volume? ZERO. Sure you can assign a probability to this event, but that again is based on past experiences, your perception of the future (biased) or the latest study carried out by McKinsey & Company. Historical data and manager-biased probabilities don’t seem to have too much of a practical basis for me.

The Capital Asset Pricing Model: The basis for this model was set by Harry Markowitz as a tool for reduced risk through stock diversification. It is used commonly by investment professionals (investment bankers, asset managers, etc.) to determine the cost of equity and ultimately is a tool for intrinsic valuation. My issue with this measure is with two of its components: the beta and the market risk premium.

Beta: Simply put, a firm’s beta coefficient tracks its performance vs. the overall market. This is calculated using historical returns of the firm vs. an index as a benchmark. The problem here, is in its historical returns. The same issue pertains to market risk premium, which again, is the difference between the return of the market and the risk-free alternative (usually long term government bonds). Essentially, the underlying principle is that we can use yesterday to predict tomorrow. Had that been the case, why couldn’t we prepare for the credit squeeze? Or 9/11? Or most importantly, my getting rejected by that girl in Grade 10?

Sure there are adjustments. My favorite is the adjusted beta, which is a weighted average of the raw beta and the beta of one. The underlying principle here is that the firm’s beta over time will move towards one. But in how long? These assumptions will only work when the economy is doing well, and I can prove that to you. It’s much easier to determine how much of the next i-toy Apple will sell when the economy is booming – it’s as much as they can produce! But during a downturn, they know their sales will decline. By how much, is another story. And it still works if you exceed the expectations you predicted with your “adjusted beta”, because now, you just call excess returns “alpha”. I cannot imagine living in a world without financial jargon. For one we won’t have any more “cool kids” who walk the walk and talk the talk.

Oracle wasn’t joking when it named its predictive modeling software package “Crystal Ball”. I guess what I am really driving at over here is that if I were to value your company today at $100, based on a stream of payments I forecast using historical data that you should receive over the next 10 years, I am taking a pretty risky bet. It’s a nothing more than a gamble window dressed to look like there may be some theory behind it.

You can’t predict the stock prices tomorrow, but pro forma statements modeled 5, 10, 15 years into the future are a great way of measuring intrinsic value? As I mentioned earlier, I’m no expert on the subject. I am simply a confused student trying to make sense of the complicated world. Maybe investor expectations and forecasts are just fundamentally flawed and we have grown too accustomed to them. Maybe we need to forget the idea of looking at future profitability and create a system that focuses more on today – for instance, today’s cash flows, rather than tomorrow’s. Unfortunately, this comes with its own set of problems, as you will have managers becoming short-term oriented, the credit system lacking its basis of information (does it really have one today?), and the fundamentals of corporate finance having to be completely re-written.

There are some serious information gaps here and for lack of a better understanding of what’s really going on, I am forced to sit back and nibble on my pen cap as I hear the words, “Historically, Yogi Bear Inc. has….”
Last Updated ( Saturday, 06 December 2008 )