Rigged or Not, You Can’t Afford to Ignore the Stock Market

Is the stock market rigged? If you bought a stock like Twitter at $70 when the analysts were telling you to buy, then sold it four months later at $30 when the analysts told you to sell, you just might think so. The idea that the stock market is rigged is as old as the stock market itself. There are most certainly individuals and institutions who maintain an advantage over others due to their size or access to information. And while these advantages are questionable, it doesn't necessarily mean that the average investor should avoid stocks altogether. The fact is, the stock market has been the best performing asset class and Main Street has benefitted from this. So how does one avoid getting Twittered? Learn the basics of what drives the stock market in the long run versus the short run.

Twitter is a classic example of how momentum and euphoria trump basic fundamentals. While the company impacts many sectors of society, the company's business model has yet to be determined. That's not to say that the smart folks at Twitter won't figure it out. But if you're trying to value the company, good luck. Any valuation number is derived from a heavy dose of speculation. In other words, if you buy a company like Twitter at $70, you need to understand that you will be in for nothing less than a roller coaster ride.

Normally, stocks are valued one of two ways: discounted cash flows or comparable multiples. The first of these is based on the sum of future expected cash flows discounted to present value. In other words, in today's dollars, it tells you how much all the cash generated by the company in the future would be worth today. In the case of Twitter, it's nearly impossible to determine how much cash, if any, it will generate. The discounted cash flow method doesn't work well here.

The second method measures a company’s value based on some type of earnings multiple such as price to earnings. For example, if the industry average PE multiple is 15 (share price divided by earnings per share), then Twitter's stock should trade at 15 times its earnings. A couple of problems present themselves: 1.) it's difficult to calculate an industry average PE multiple without direct competitors and 2.) it’s nearly impossible to apply this method when a company has negative earnings.

That brings us back to our original point. The stock market is not rigged but trading highly speculative stocks like Twitter might make you think it is. That's not to say you shouldn't invest in these companies. Just be aware of what you're getting yourself into.

 

Reuben Advani is the president of The BARBRI Financial Skills Institute. More information on this and other topics can be found at http://legalpractice.barbri.com.

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