Got this in my inbox this morning via Capital Minded and thought it was a pretty interesting read, figured I'd paste it here to share with the group:
So why'd Facebook drop 20% yesterday?
So Facebook beat earnings expectations but missed revenue expectations…however neither of those things are the true culprit. The biggest reason the market discounted 1/5 of the company’s value is because of the future guidance given by Facebook’s team that revenue growth will dramatically slow in the future. This piece of information is extremely important…like, 20% of the company important.
Your eyes will probably glaze over at the next few paragraphs (I’ll try to rephrase the jargon into human speak) but bear with me. Understanding this is what separates “dumb” retail money trading on phone apps from the professional investors:
Today is tomorrow discounted
The fundamental idea underpinning finance is that the value (or price) of something—a company, an apartment, a patent, etc.—is determined by adding up all of its future income potential and then discounting that to the present. As William Bernstein would say, this is “the closest thing you’ll find to a law of gravity in financial markets.”
I will spare you the mathematics (google the Gordon equation or CFA for more info), but just know there’s many different equations for doing this used by institutional money and high frequency algorithms to distill decades and decades of predicted future into one number today.
Basically the most important inputs in a lot these equations is the discount rate and growth rate. This is again, a (somewhat wrong) oversimplification, but its helpful to think of the discount rate as based on the environment. This means interest rates, inflation, and market risk (beta).
Since nobody knows the future, the discount rate is an educated guess that is constantly being adjusted. It moves every time data is released (ie. the federal reserve raises interest rates or inflation data is published). The company’s future growth rate is projected and immediately adjusted based on all company data released to the public.
Hence, the stock market is a giant exercise in taking a bunch of data inputs (company earnings data, inflation data, interest rates, etc.) and plugging them into this equation to adjust prices more accurately as the future becomes the present. It’s a noisy activity, hence the volatility, but in the long run its a thing of beauty.
Essentially what happened here is the market got a new input to lower the growth rate on FB’s value equation, and the stock adjusted accordingly.
But what about GDPR and Cambridge Analytica and my friends aren’t on Facebook much anymore and blah blah blah?
Retail (at-home) investors make the mistake of thinking a stock’s price is simply our collective emotional feelings about a company. This is true for an asset that generates no income (ie. anything crypto), however the stock market is grounded in the equation I explained above.
Yes, the latest privacy scandal was a disaster for both the company brand and the entire system of American democracy, but Facebook’s CFO already issued a warning about revenue growth slowing down a full 2 years ago, long before Facebook’s latest privacy indiscretions were front page news. It’s clear Facebook knew that growth was slowing and that they would need to adjust their platform to be less of a clickbait machine long before the Cambridge Analytica scandal. It took a full 2 years for the market to see the specific data and guidance it needed to adjust however.
The Folly of Man
As explained above, the modern stock market is a mostly efficient means of taking all available data, and implementing it into stock prices in a matter of milliseconds. The efficiency is at its peak in the biggest and highest profile companies like Facebook. Hence, why “trading” from your phone when you don’t have any information that’s not public, is a fool’s errand. The market will move the millisecond the information is released, and it will move faster than you can blink.
Submitted July 26, 2018 at 07:08AM by behavioralsanity https://ift.tt/2NLocDr
