In Practice Reconciling your value with the market price

When you value a company and arrive at a number very different from the market price, as we have with both Aracruz and Deutsche Bank, there are three possible explanations. The first is that we are mistaken in our assumptions and that our valuations are wrong while the market is right. Without resorting to the dogma of efficient markets, this is a reasonable place to start since this is the most likely scenario. The second is that the market is wrong and that we are right, in which case we have to decide whether we have enough confidence in our valuations to act on them. If we find a company to be under valued, this would require buying and holding the stock. If the stock is over valued, we would have to sell short. The problem, though, is that there is no guarantee that markets, even if they are wrong, will correct their mistakes in the near future. In other words, a stock that is over valued can become even more over valued and a stock that is under valued may stay undervalued for years, wreaking havoc on our portfolio. This also makes selling short a much riskier strategy since we generally can do so only for a few months.

One way to measure market expectations is to solve for a growth rate that will yield the market price. In the Aracruz valuation, for instance, we would need an expected growth rate of 19.50% in earnings over the next 5 years to justify the current market price. This is called an implied growth rate and can be compared to the estimate of growth we used in the valuation of 5.31%.

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