At the same time, the valuation of a financial asset rests on discounting its future free cash flows (cash flows after capital expenditures and other investments).
This is true for any asset, whether it be a rental property, a timberland, a bond issued by the city of Saint-Jérôme, a potential gold mine, or IBM stock.
For any asset, the work of an investor is to assess future free cash flows, discount them to a present value, and determine whether this estimated value is higher or lower than its current price. This is the foundation of investing.
Obviously, even though this method of valuing an asset is simple, its application is far from easy and precise. For many assets, except perhaps a bond, it is difficult, if not impossible, to project future free cash flows with accuracy. And even if one could, the question would remain of which discount rate to use in bringing these flows to present value, depending on numerous parameters, including our estimate of risk. In short, the valuation of most financial assets rests on highly uncertain projections. Even though mathematical models allow us to calculate the value of any asset with great precision, the whole process relies on very uncertain parameters. Finance is a discipline that blends science and intuition.
This is where the notion of “margin of safety” becomes crucial. It is indeed essential to be conservative in the valuation of an asset and to allow for a good safety cushion by trying to buy it at a price significantly below our estimate of its value.
I believe it is precisely this great uncertainty, together with the considerable role of dreams and hope, that regularly generates periods of intense speculation and enthusiasm in the stock markets. I also believe that this same phenomenon explains why the assets that usually attract unbridled speculation are those that arouse feelings of hope and dreams but are still far from generating free cash flows. Some mining speculators prefer buying shares of mining companies before they exploit their mines, believing there is a greater chance that their projects will inspire dreams and command high valuations. For once a mine is in operation, its valuation tends to reflect its economic results.
These days, there is considerable enthusiasm for assets related to artificial intelligence. For these securities, in my view, we see both characteristics that fuel speculation: dreams and the difficulty of valuing the asset. In such a situation, we are in the realm of speculation and not investment.
Everyone agrees that the potential of AI is enormous and that the economic impact will be huge in the coming years. This is what fuels the dreams of many speculators. At the same time, it is still very difficult to know where this technology will lead us, who the winners will be, and whether the sector will prove profitable for the companies involved. For most companies in the sector, profits and free cash flows—especially given the massive investments they must make—remain uncertain, if not nebulous. This is, in my opinion, what is creating the current enthusiasm for AI-related stocks.
One day, however, we will begin to better discern the business model of the AI industry, the revenues it can generate, the companies that could take the lead, and the profits they could produce. It will then become easier to value these companies. That is probably when many stocks, now carried by dreams and speculation, may come back down to earth.
Philippe Le Blanc, CFA, MBA
Chief Investment Officer at COTE 100
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