Last week a friend and I were talking about the stock market when he asked me why the most speculative stocks were also the most volatile. No sooner did I get the words "day traders" out of my mouth when he shushed me and said, "You blame everything on the momentum crowd, Pat. Give me an answer based on the fundamentals."
OK, fair enough.
Basically, the value of a stock is equal to the value of the free cash flows it produces in the future, discounted back to the present. (When you "discount" future income, all you're doing is adjusting for the fact that a dollar in hand today is more valuable than a dollar to be received in the future, because today's dollar can be invested to generate a return.)
Stocks that are speculative tend to have a lot more future dollars than current dollars. So, most of their worth lies in the future - because their future cash flows are expected to be much higher than their current cash flows.
Since we can't know exactly what the future will bring, we have to estimate the size and timing of those future cash flows. Estimating cash flows is not an easy process, even for established companies. For firms operating in markets that didn't even exist a year ago, it's virtually impossible.
As a result, seemingly inconsequential pieces of data - about a competitor, a growth rate, or the potential size of a market - can have a gigantic effect on the current value of a young company. So, if small changes in the amount of available information can lead to big changes in the value of the stock, and information is constantly changing - voila! You've got volatility.
As an example, let's use OptoWidgets, which is making optical networking gear so advanced that it will make a honkin' big fiber-optic cable look like a soda straw. If OptoWidgets makes $5 million this year, and I think it can grow at 50 percent per year for the next four years, then the company will make about $25 million in 2004. A discount rate of 10 percent gives those cash flows a present value of about $17 million.
But what if the company runs into production difficulties and says its new stuff will hit the market a year later than planned? Ratcheting down my first-year growth expectations to 20 percent - while still keeping estimates for the remaining three years the same - gives me 2004 cash flow of only $20 million, which has a present value of $14 million.
So, a relatively small change in my expectations lowered the present value of the company from $17 million to $14 million, or 18 percent. Imagine this happening hundreds of times per day for hundreds of stocks, and you'll have a partial idea of why the market has become so volatile.
When stocks are being valued almost solely on future expectations - as many of the market's hottest stocks are - the slightest change in the information used to form those expectations can drastically change the market's assessment of these stocks' worth.