Past Equal To Future?
We have to take note that since expected returns we expect to receive from a stock investment is based on assumptions using past returns, we are basing the assumption that the past would equal to the future.
This assumption would not be relevant if an asset’s character has changed. If it has– the historical measures are no longer relevant to come out with assumptions to value the stocks– for example when coming out with the earnings growth and the cost of equity.
What Have Changed?
A lot of things would have changed from the past– the trends in global asset allocation and their determinants differ according to economic conditions and financial crises. Due to certain catastrophic events such as the 2008 financial crisis, some companies’ policies have already changed– in order to hedge again future financial crises or preventing them from happening again.
The ease of getting capitals at a low (close to zero) interest rate in United States have been a large cause in the bull market run that has been happening since 2009– the fall and rise in the interest rate set by the United Government would affect all companies as this is a market risk– albeit certain firms would be more affected– such as financial firms.
Examples Of How Judgement Is Used In Valuations
The model we use in valuations of stocks is mostly based on facts and figures but the truth is a lot of judgement is needed. For example, when we find out that a particular company has managed to grow its earnings per share by 10% for the past 10 years, can we safely assume that they will continue to do the same for the next 10 years?
In this case, we would have to judge for ourselves on whether the industry that the company is operating in will become more competitive in the future? Would they have the competitive advantage to fend off competition and maintain they earnings growth? Would they be able to maintain their gross margins?
As you may have seen, some of the answers are more qualitative than quantitative and these are questions that need to be answered– especially so for a savvy investor who knows that he cannot assume that past return is equivalent to future return– albeit there is merit in and it is important too in using past return to estimate a future return.
Disclaimer: The information provided is for general information purposes only and is not intended to be personalised investment or financial advice.
Important: Please read my full disclaimer.
CHRIS LEE SUSANTO
Hi, my name is Chris and I am the founder of Re-ThinkWealth. A blog that focuses on personal finance self-improvement, investments, and investor psychology.
Since early 2015, I manage money for my family and invests it in Singapore and United States equities and options achieving above market return.
I use Value Investing and Options Selling strategies used by Warren Buffett (World’s richest investor) coupled with the core theory of inversion. Inversion meaning that in every investing idea, we have to scrutinise on why it would fail.
This will result in us being more conservative, and being conservative is the key to protecting and growing wealth in the long run.
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