Valuation Trap Psychology

Have you ever wondered how the valuation of an asset actually works? How do we know how much exactly to pay for a share of company XYZ?

Many professionals will make up sophisticated theories to answer these questions. However, few of them actually possess the most basic level of understandings. In fact, the current market experiences a tremendous degree of mis or lack of understanding, which has caused many cases of over-valuation.

We all know that if a factory has 1 million dollars on its book, we can safely pay 1 million to buy it. Similarly, if a bond has a future value of 11 million dollars with a maturity of 1 year, we should pay 10 million dollars, provided if the discount rate is 10%. Book value and present value are taught in every single college intro economics and finance classes. However, unsurprisingly, in the life-and-death market, it is far from this simple. Many businesses have little on their book and even produce a negative cash flow and earnings, but we see their companies being valued at millions, and even billions. Curious minds must ask, “What is the driver of these valuation levels?”

The truth is, there is no logical reason.

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That is the sad truth of Wall Street and the market. If a business is not profitable, has mountains of debt, and will not likely turn profitable anytime soon, the bottom line is that, there is no reason for anyone to pay more than their book value to buy it. Certainly in the day-to-day life, you have the clear sense not to run a business that loses money today and will continue to lose in the future.

But… this certainly cannot be the case. It doesn’t make sense. Every year, thousands of people fly to Silicon Valley to try to scout “the next big thing”, “today’s Steve Jobs”, and “the future.” And these people are ready to pay! I mean, they are actively looking for reasons to empty out their pockets for the hopes of someone else making them really, really rich! Most of these tech businesses are grossly overvalued from day 1 and typically will continue to be so until a few months after the founder rings of the Wall Street bell and the market gives the investors a wake-up call. And that is actually the 0.1% success story! Surely, something has to be wrong here when the trading floor is viewed as the end goal. Something is unhealthy with the mindset which people have, and something is clearly wrong with way assets are being valued.

To put it bluntly, I believe people make investments, with the goal of being acknowledged by others in a later time, instead of doing so out of an internal belief that the business is good. What does it mean? Suppose John invested 1 million dollars in a Silicon Valley start-up for 5% of the ownership. The business is losing money and worth much less on paper than what John paid for. Next year, Sean comes around and paid 2 million dollars for 5% of the ownership. John is jubilant. In his mind, he made a successful investment. He had doubled his money in 1 year. That is simply not the case. John is still invested in the equity. The fact that there might be someone even more stupid than him does not give way to the claim that he made a successful investment.

This is the world we live in. We want others to come around and pay more than we did, in order to show us that we made the correct move. In reality, it might just be that those people are even knowledge-less than we are. If I blocked out the big brand names of many companies, and just showed people the sheer operating numbers, many companies would be crossed off the list of “investable companies.” If I take it a step further, and tell the people that these companies are private companies with extremely low trading volatilities, I bet only a handful of companies would survive the scrutiny.

Buffett said that if you invest like the market will be closed for the next five years, you will do very well. I say, if everyone invested like that tomorrow, 90% of the stocks will crash more than 50% in value, because that is by how much they are overvalued.

Finally, if you fully embrace your intelligence and invest with genuine confidence, you will have hopes of becoming a good investor, for you don’t need to seek out external acknowledgement on your investment decisions and you can firmly stand behind what you know and believe in.

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