Hey guys I had an idea and I'd like some feedback.
I am an undergraduate economics student and I really love the ideas that come from value investing, so maybe the wrong forum haha.
The value investors thesis is that a rational investor would never pay more than 1$ for every dollar of discounted earnings. You could split this into no growth earnings and earnings from growth as formalized by Greenwald:
\(P=EPV+V_g\)
\(EPV=\frac{NOPAT}{r}\)
\(V_g=EPV \times\frac{g}{r - g}\)
The issue is that markets persistently pay more than the fundamental value of a company, meaning that price does not revert around the fundamental value. The value investors response to these kinds of companies is to claim it is "overvalued" and wait for it to come down to a multiple it will never reach.
My idea is that we can decompose share price into 3 layers:
1. no growth earnings (the earnings the company can reliably achieve without needing to speculate about growth)
2. Potential earnings from growth
3. A speculative residual
\( P(t) = EPV(t) + V_g(t) + \Delta(t)\)
This means we can break demand into 2 components:
1. return seeking investors who compute fundamental value
2. ownership/utility seeking investors who invest for another reason like brand, franchise quality, narrative, scarcity or reflexive price history.
This is where I need the input, how do I calculate the residual?
The idea I thought could solve this is the assumption that markets efficiently priced in near term growth during the companies history.
This means you could calculate the residual for every point in the companies history. The issue is that this has look ahead bias in a back-test?
\(g(t)=\frac{\text{NOPAT}(t+1)-\text{NOPAT}(t)}{\text{NOPAT}(t)}\)
\(V_g(t)=\text{EPV}(t)\times\frac{g(t)}{r - g(t)}\)
Once we have the residual calculated you could essentially find each companies intrinsic value, or how much more people are willing to pay per dollar for the company. ie $1.50 per dollar earned. Then you could create new standard deviations around how earnings have been priced.
Coincidentally this also feeds well into George Soros' ideas of price reflexivity, meaning price is apart of the fundamental value. This is because if the residual is increasing over time, the difference between fundamental value and SP will be increasing which could be from price reflexivity.
I have thought more deeply about it but cant fit it all.
please feel free to critique it, i dont really know what im doing.