Manic Meets Math

“HOW BAD WILL IT get—and how long will it last?” In my last article, I mentioned that many people had asked me those two questions. This past week, amid the continuing stock market tumult, some folks have been raising a third question: “Should I even bother investing in the stock market? It just seems crazy.”

It’s a fair question. On Monday, the market was up 4%, before dropping 3% on Tuesday. On Wednesday, it was up 4% again, but then lost 3% on Thursday and another 2% on Friday.

Think the stock market is crazy? You aren’t alone. Warren Buffett calls it “manic-depressive.” Howard Marks, one of the clearest thinkers when it comes to investing, has observed that investor sentiment tends to oscillate between the extremes of “flawless” and “hopeless.”

With the market’s extreme behavior over the past few weeks, it’s hard to refute these characterizations. So should we simply write off the market as crazy and unpredictable? To answer this question, it’s worth taking a step back and looking at what drives share prices. As I see it, there are three major factors:

1. Corporate profits, including expectations for future company earnings.
2. External events, including political news, economic developments and, of course, health scares.
3. Investor sentiment.

From day to day, the share price of each individual company reflects some combination of all three factors. In recent weeks, however, there’s no question that Nos. 2 and 3 have been in the driver’s seat. The coronavirus is almost entirely responsible for the market’s drop. But over the long-term, it’s No. 1—corporate profits—that has the largest impact on stock prices.

If that’s the case—if corporate profits matter most over the long term—then how much should we really worry about the stock market’s decline? To put it another way, is the market’s recent drop warranted or is this just the temporary, irrational result of widespread panic?

To answer this question, let’s look more closely at No. 1 and the math behind stock prices. To illustrate how this is done, I’ll use a simple example: Procter & Gamble, the maker of Pampers, Ivory soap and other household products. Today, P&G is worth about $300 billion. The question we want to answer is: Would P&G still be worth that same $300 billion if the coronavirus brought the economy to a standstill?

The textbook method for valuing a stock is known as discounted cash flow. To do this calculation, you total up all of a company’s estimated future profits, on the notion that a company should be worth the sum of all profits it could produce over its lifetime. Discounted cash flow analysis then applies a “discount” to each future year’s profits based on the principle that a dollar next year is worth less than a dollar this year.

Last year, P&G’s profits were about $10 billion. If we make some basic assumptions about future earnings growth, we can calculate the total value of P&G to be about $300 billion. This, mathematically, explains the current stock price.

Now we can answer the earlier question: What would happen to stock prices if the health situation got worse—if everyone were quarantined and the economy ground to a halt for the rest of the year? The math here is fairly easy. If P&G’s future profits add up to $300 billion, and we remove one year of profits—assuming P&G earns nothing this year—then the company should be worth $10 billion less. While $10 billion is a big number, it represents just 3% of P&G’s total value. In other words, based on the numbers and assuming an extreme scenario, the company’s share price should drop by just 3%.

If the economy did slow materially as a result of the virus, some companies would be affected more than others, but the general idea is this: The stock market value of any company represents all future potential profits—and thus any short-term losses should subtract just a small sum from a company’s overall worth.

I fully acknowledge that, at times like this, most investors aren’t sitting down and doing discounted cash flow analysis. For now, sentiment has taken over. But this math does explain my “don’t panic” view of the situation. No question, this is all very unnerving—and things could get worse before they get better—but I wouldn’t get caught up in the panic. I wouldn’t sell out of stocks, and I wouldn’t fear that all this will cause lasting or irreparable damage to stock market investments. Yes, the market goes to extremes in the short term. But over the longer term, I believe rationality will prevail.

Adam M. Grossman’s previous articles include What Should I Do, Don’t Tinker and Adding the Minuses. Adam is the founder of Mayport Wealth Management, a fixed-fee financial planning firm in Boston. He’s an advocate of evidence-based investing and is on a mission to lower the cost of investment advice for consumers. Follow Adam on Twitter @AdamMGrossman.

Do you enjoy HumbleDollar? Please support our work with a donation. Want to receive daily email alerts about new articles? Click here. How about getting our newsletter? Sign up now.