Our same friend dropped by again, (link to first conversation), this time he wanted to talk about these multi-colored parallel lines on our model price charts which we call Economic Book Value (EBV) lines. This is a summary of our conversation.
I’m here for more learning!
Friend – Thanks for the explanation last week on model price. I now look at model price with new eyes. I still have follow up questions maybe we can drill down further sometime in the future.
ModelPriceGuy (MPG) – We are here to teach new financial concepts to anyone willing to listen in the hopes they will help new users with what they have learned. It’s about the model price community, and it’s our hope we can all profit together.
Friend – Thanks. These parallel lines look so simplistic to me. How can they help me invest?
ModelPriceGuy (MPG) – We call these parallel lines Economic Book Value (EBV) lines because we start with the green line we call EBV. We call this EBV so we don’t confuse accounting types who can calculate accounting book value. We calculate accounting book value and add what we call Theoretical Earnings (TE) to get our EBV. If we called our EBV, book value, we are sure accountants and others would be confused when they tried to reconcile our definition of book value with theirs.
Friend – OK, Theoretical Earnings?
ModelPriceGuy (MPG) – Simply stated, TE is the amount of earnings a company needs to maintain equilibrium of their balance sheet. In other words, the amount of earnings the company needs so the balance sheet neither expands nor contracts. We illustrate the EBV line on a logarithmic graph over a period of time.
Visually you can easily follow the growth of book value, our definition, over a period of time for ease of analysis. Believe me, this is easier to follow then a column on numbers that are usually given by analysts’ and CFOs’ of companies.
Yes, thanks ModelPriceGuy, I’m free of numbers.
Friend – Seems easy enough. So what about these lines parallel to the green line or EBV?
ModelPriceGuy (MPG) – These lines are a function of the EBV line. We have found “break points” in nature that have relevance to the financial world. When stock prices interact with these “break points” amazing things tend to happen. First, these “break points” tend to supply support and resistance lines for stock prices. Second, transits of these EBV lines have meaningful information. Positive transits mean the fundamentals are improving for the security. Negative transits mean the fundamentals are deteriorating.
So to summarize, stocks trade every trading day. Stocks move up, some move down. Most stocks will trade within their already established zones. Some stocks will transit, positively and negatively giving the user valuable information on the changing fundamentals of the companies they are interested in.
Friend – Why do you graph these parallel lines over a period of time?
ModelPriceGuy (MPG) – This helps the user, very quickly, establish valuation zones in the past that has had relevance to their interested security. If a company has never traded above EBV+5, in the past, and the stock price is just under EBV+5, then there is little likelihood of a positive transit, and price appreciation to EBV+6.
Friend – What role does model price have with the EBV lines?
ModelPriceGuy (MPG) – Model price and EBV lines are two separate calculations and concepts. However one can use model price to determine what zone a security should be trading in. If model price is a couple of zones above the current price and there is a positive transit further gains will probably be likely. The reverse is true on the downside.
Friend – One last thing, I have seen you mention volatility in price a few times in the blog in relation to these EBV lines. Can you review this again with me?
ModelPriceGuy (MPG) – Sure. First, we look at weekly price bars. You will notice, must of the time, prices inter zone can have higher volatility than prices when they congregate around these structural zones. To us prices feel comfortable around these EBV lines. They are less stressed, if you will, or they have something to cling too. Structure. Yes, we know it sounds weird however you can observe this on your own by looking at your favorite stocks.
“Goldman Sachs just transited above EBV-3.”
Friend – Thanks. My head is starting to hurt again. Let me go away and think about what you have just said.
ModelPriceGuy (MPG) – Sure come back anytime.