Sharemarkets do not like uncertainty. In fact, sharemarkets tend to discount for uncertainty. That means that investors are willing to pay less for a stock when there is rising uncertainty.
The value of a share is derived from the perceived future cash flows of the business. Of course, adding up all the potential cash flows of a business is like saying 'How long is a piece of string?' What stops stock valuations from going to infinite proportions is the time value of money.
The time value of money is the concept that money today is worth more than money tomorrow.
Say you won the $1 million lottery. If you had the option of taking the money today or in 10 years' time, most people would logically prefer the money today. That's because in 10 years' time the spending power of $1 million would be significantly less due to inflation.
There is also an opportunity cost. In 10 years, your $1 million could be put to work. Look at a term deposit: $1 million at 5% compounded quarterly over 10 years would be worth $1.6 million.
So share valuations take the future cash flows of the business discounted back to today's value using a risk free rate — typically the cash rate or a long-term bond rate.
So how do you value shares when there's so much uncertainty in the sharemarket?
We can gain insight on how this is done by looking at valuations for options. Valuing options takes into account three key factors:
Now, when it comes to share investments, time is not relevant because there is no set expiry date for shares.
The underlying asset is based off share valuations which we discussed above.
That leaves us with volatility but is volatility a factor when it comes to share prices?
When there is great uncertainty, fear dominates the sharemarket. Often that fear is gauged through volatility. In the US, that gauge is often referred to as the fear index or the VIX.
So do share prices also take into account uncertainty?
Here's the implied volatility index for the Australian market (blue line) versus the benchmark ASX 200 index (black line). You can see that they move in opposite directions, meaning they are negatively correlated.
As uncertainty rises, share prices generally go down.
The good news is that implied volatility is relatively low at the moment which could indicate share prices are on the rise.
While stock prices tend to reflect future cash flows, uncertainty is also a consideration. Low volatility is frequently associated with markets rising and high volatility is associated with markets falling.
The key here is to understand that volatility eventually reverts back to the mean. So for savvy investors, those spikes in volatility can provide potential trading opportunity.
So when you look at share valuations that seem attractive make sure you take into account another dimension — uncertainty.
Happy trading!
Julia Lee Equities Analyst Bell Direct Have you started trading with Bell Direct for just $15 a trade? Register now for free.