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The Smart Way to Think About Wild Markets

On Charlie Rose this week, Felix Salmon made a good point about market volatility:

“It is impossible to know the value of a company like Apple or Goldman Sachs to within a half a percent either way. But that’s what you wind up doing when you look at the stock price. You say, “Oh it went up a percent! Or down a percent!” That is pure noise in the distribution of roughly, more or less, where we think [the price] should be.”

How true. And this is something that private companies handle better than public companies.

When a private company wants to know how much it is worth, management hires an investment bank, or a valuation consultant, which provides a “fairness opinion.”

Analysts look at the company’s financial statements, do some wizardry in Excel, and come up with a reasonable estimate for what the company is worth.

But when an investment bank presents a private business owner with a fairness opinion, you will almost never see this:

We think your company is worth $18.16 per share.

Instead, you’ll almost always see something like this:

We think your company is worth between $17 and $19 per share.

Valuations are given in a range, not an exact value.

There’s a good reason for this.

All valuation estimates are just that – estimates. They’re an attempt to predict a future that, in reality, cannot be known.

To value a company, we have to know what future interest rates will be, for example. But we don’t. And we can’t.

We can, however, come up with a reasonable range of possibilities.

No finance professional can look at you with a straight face and say Singapore’s 10-year government bonds will yield 4.21% in January 2017. But if they said there’s a good chance the 10-year bonds will yield somewhere between 3% and 5% in January 2017, that’s more realistic. (The range could still be off, but it has a better chance of being more or less right.)

Same goes with earnings growth, capital spending, cost of goods sold, and dozens of other variables. The future is thought of in a range of probabilistic outcomes, so current valuations are presented in a range, too.

But the stock market doesn’t.

At the end of Friday, Keppel Corporation Limited (SGX: BN4) was worth S$9.17 a share. There’s no range of possibilities — not “between S$9 and S$11 a share.” The exact value, right now, is S$9.17. That’s what the market estimates Keppel Corporation’s future cash flows are worth, discounted back to today.

But not even the market, which aggregates millions of opinions into a single price, can know exactly what the future holds. We can only make reasonable estimates about a range of outcomes.

The reality is that, even if Keppel Corporation (just to use an example) is priced at S$9.17 a share, there’s a range of prices that would be reasonable to pay.

Thinking of values this way should change how you react to short-term volatility.

When a stock goes up or down, even by a few percentage points, there’s a tendency to think the market is trying to tell you something. That it’s signaling your company is worth less, or more, than it was a day ago, or a few weeks ago.

But that’s rarely the case.

The majority of stock movements are just random wobbles within a reasonable valuation range. Keppel Corporation shares falling from S$9.17 to S$8.90 might not mean anything at all. It might just mean that shares are probably worth something between S$9 and $11 (this is just for illustration’s sake and is not meant to suggest that Keppel Corp’s shares are really worth that amount), and anything within that range means more or less the same thing.

“But nobody thinks about markets that way,” Salmon said. “Although they should.”

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. This article was written by Morgan Housel and first published on fool.com. It has been edited for fool.sg.