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From: kapil@dartvax.UUCP (Kapil Khetan)
Newsgroups: net.invest
Subject: Re: Stock market is NOT a present value machine
Message-ID: <4313@dartvax.UUCP>
Date: Sat, 15-Mar-86 20:36:21 EST
Article-I.D.: dartvax.4313
Posted: Sat Mar 15 20:36:21 1986
Date-Received: Mon, 17-Mar-86 03:27:06 EST
References: <2023@uwmacc.UUCP>
Reply-To: kapil@dartvax.UUCP (Kapil Khetan)
Distribution: net
Organization: Dartmouth College, Hanover, NH
Lines: 39
Keywords: You are ignoring the discount rate
Summary: 

>Someone mentioned that the stock market is just a present value machine
>This can't be totally true, because then every stock with a given P/E
>ratio would sell at exactly the same price, right?  A quick glance
>at the stock listings shows this not to be the case.  Comments?
>
>	Jeff Percival ...!uwvax!uwmacc!jwp

Correct me if I have misunderstood your question, but what you are 
getting at is "if the stock market is a NPV machine then companies
with a certain earning should have the same price, therefore
producing the same P/E ratio." 

You have not taken into account the other component of NPV besides
the cash flows (earnings), and that is the rate to discount them at.
This rate depends on a lot of factors especially, the company's
financial structure, the industry it is in, it's past earnings
record and so on.

The Capital Asset Pricing Model gives an indication of the discount
rate if the following are known: the company's beta, the rate of
return for a risk-free rate, the rate of return for a market 
portfolio. It simply says, the more volatile the stock (beta)
the higher the discount rate. This is why Treasury Bills have a
very low return (being safe and non-volatile) and stocks in
hi-tech companies are discounted at high rates.

Thus you might notice that IBM has a very high P/E multiple. This
is because it is safe and is not very volatile (the beta should be
just slightly higher than 1.0). On the other hand a high-tech
company will not have a very high P/E ratio. (You didn't think I
would call IBM a high-tech company, did you?)


Kapil Khetan
kapil@dartvax.UUCP
kapil%dartmouth@csnet-relay.ARPA
kapil@dartmouth.CSNET

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