With global stock markets experiencing high levels of volatility, it is timely to build on the time value of money concept discussed in my last article and look at what makes up a public company’s share price.
As the name suggests, a share is a fractional interest in a company. Therefore, a share is worth the value of the business operated by the company, divided by the number of shares outstanding.
In simple terms, the business is worth the sum of its future cashflows in today’s dollars. You will recall that this ‘present value’ can be calculate by ‘discounting’ those future cashflows by a discount rate equivalent to the opportunity cost of the capital invested to establish and operate the business.
Arriving at the appropriate discount rate which properly reflects the opportunity cost of capital is a complex process, over which leading finance experts often disagree. However, the concept is not difficult to understand: it is the rate of return expected from an investment of similar risk. This is essentially made up of the return on so-called ‘risk-free’ securities (e.g government bond yields) plus a risk premium an investor requires given the risk of the business relative to overall market risk (‘Beta’ in finance speak). The cost of debt capital also plays a role.
During times of uncertainty and higher interest rates, this cost of capital increases as investors demand a higher return for the risk they are taking. The higher the discount rate, the lower the business value and the lower the share price.
Unlike property or private businesses, the value of a public company is literally set and re-set hundreds of times a day as buyers and sellers trade shares and agree a price. This explains why current uncertainty concerning the global economy, the Ukraine conflict and expected US interest rate rises, is causing a lot of volatility in global share markets.
However, not all investors look at risk the same way, nor apply detailed analysis before making decisions. Therefore, emotion and other idiosyncratic characteristics add to this volatility and can present opportunities for the disciplined long-term investor.
Korff Wealth is a Corporate Authorised Representative of InterPrac Financial Planning Pty Ltd ABN 14 076 093 680 Australian Financial Services Licence Number 246638, Level 8, 525 Flinders Street Melbourne VIC 3000
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