Yes, our curious and insistent friend, dropped by to have a more in-depth conversation on model price. A summary of the conversation went like this. (See Part 1 here)
Yes, I'm here to learn some finance.
Friend – I think I get what you are doing with model price. You’re giving me, on a daily basis, a calculation of what the fair market value is on any and every company in your Facebook database. You have also pointed out situations in your blog (here, here and here) where transactions were announced that have confirmed your calculation of model price. So my question is, do you have the same degree in confidence in all stated model price calculations in your database or does it vary?
ModelPriceGuy – It varies. The critical factor is the variance in earnings estimates. For every reasonable large cap company there are a number of analysts who follow every detail of what the company does, including giving earnings estimates of what the company will earn not only for the next quarter but also for the next year. For those who don’t know, this is a very competitive field, and the most accurate analyst will be noticed by way of remuneration and industry awards. To us there is a lot of information when you look at analysts’ estimates as a group. An important piece of information is the high, low, mean estimate range. (Also, we look at the number of analysts making the estimates. This is not a problem for US companies. Unfortunately in Canada, there maybe only 1 or 2 analysts, which is better than nothing however a consideration when evaluating model price.)
Friend – OK, let’s stop here. Where do you get this information?
ModelPriceGuy – You can go to finance.yahoo.com. This is just one site, there are many others including Bloomberg and Thomson Reuters. But let’s keep to finance.yahoo.com. So place a quote of a stock in the appropriate box, say Yahoo (YHOO), and hit go. You will notice a left hand column, and as you look down this column you will see “Analyst Coverage” and below that you will see “Analyst Estimates”. Click on this and a lot of information will be displayed on what analysts’ are doing as a group.
Friend – Wait, this seems complicated. I thought you said I would be free of numbers.
ModelPriceGuy – You certainly don’t have to do this background work, we take care in downloading this information everyday. Can you image downloading this data and daily changes to this data on over 2000 securities. This is one of the reasons we have a daily computer run. Our daily computer run incorporates the latest in earnings estimates, and other variables, which can change for every one of our listed companies.
Friend – I’m no math whiz but that must be millions of calculations a day.
ModelPriceGuy – Absolutely! We tried to calculate how many calculations we did on a daily basis but we gave up!
Friend – You were saying, an important piece of information is the high, low, mean estimate range.
ModelPriceGuy – Well, important when considering the confidence a user may place on model price. When considering the high, low, mean earnings estimate a user can consider the variance of all three numbers. The tighter these estimates are, the higher confidence level on the calculation of model price. If the high and the low estimates are wide we say there is a lot of variance. Our confidence level in model price wouldn’t be as high as in the tighter earnings estimate situation. We call this coefficient of variation.
Friend – Stop, this is getting too complicated.
ModelPriceGuy – Sorry, the bottom line is, most of the 2000 companies in our database have a high coefficient of variation and our model price calculation is accurate using the mean estimate commercial services publish on a daily basis. Where model price isn’t as accurate is with highly cyclical companies especially small cap companies or companies with only 1 analyst’s estimate. (If this 1 analyst is correct, then our model price is correct, however there is safety in numbers!)
Friend – So if I could paraphrase, there is a lot of information in this simplistic purple line and obviously the amount of variables it takes to calculate this line on a daily basis is numerous. However, I think what your saying is large cap companies have an advantage in your system because with more analysts following the company the better reliability of the inputs to your algorithm the better the output, in terms of model price.
Wow! This purple model price line looks so simplistic but it's doing so much work for me.
ModelPriceGuy – Yes, that is absolutely correct.
Friend – That’s enough for now. Let me go away and think about our conversation in terms of how I invest my portfolio.