Valuation Matters

Monthly ETF Contribution

Valuation

Monthly ETF Contribution

Companies are valued based on the present value of their future cash flows. This sounds like a rather easy feat and with some Excel trickery, you should be able to evaluate a company within a couple of minutes. Unfortunately, that is far from the truth due to two main variables. 

Firstly, investors have to basically guess what the future earnings of the company will look like. Some companies do provide guidance for the next year or maybe even two years but if you are planning to hold a stock for 5-10 years it becomes very difficult.

Secondly, you need to apply some basic Economics 101 math to figure out what these future earnings are worth today. Again, this is quite challenging to predict since there are many variables that can impact the discount rate.

With some effort, you might be able to predict these with a certain degree of accuracy. So you go through the process of doing a Discounted Cash Flow valuation and just like that you know whether to buy a stock because it is undervalued or sell because it is overvalued. This investing thing is actually quite easy.

NOT! You can rest assured that all the hedge funds and every junior analyst working at Goldman Sachs or Morgan Stanley are privileged to much more data than any retail investor and they are also able to run complex DCF models every second on almost every company. If it was that easy to determine the valuation of a company, we would have seen a lot less volatility.

To understand this, we have to go back to Einstein's Eighth World Wonder, compound interests. If you are doing a DCF for a ten-year period, the slightest change in interest rates or the CAGR of the company can totally throw off your valuation. Then throw in a black swan event like Covid or WWIII and you can throw your valuation out of the window. 

Adding the complexity of all the nuances affecting a single company and you can see why diversification is so important. ETFs give you this diversification and what is even better, you don't need to predict who will be the next leaders because if they become the leaders they will automatically be included in ETFs like S&P500 and Nasdaq100.  

Portfolio Update Summary

In the last month, our ETF Portfolio has gone from red to green, primarily due to inflation coming down. Luckily we do not care about price movement or market timing in this portfolio, we will just continue making our monthly contributions. 

Disclosure

This is not financial advice and only the opinions of the author. The $28K in the ETF portfolio is not real money and is only a demonstration of a typical portfolio.  All investments involve risk, and a financial product's past performance does not guarantee future returns. Investors have to conduct their own research before conducting any transaction. There is always the risk of losing parts or all of your money when you invest in securities or other financial products.