In the last few blogs we touched at length on model price. So let’s even it up with a discussion on EBV’s or Economic Book Values.
Most, if not all, financial quantitative models, that we have seen, are based on empirical relationships. What do empirical relationships mean? Referencing ‘empirical’ in our Merriam-Webster’s Dictionary says the following:
1. Originating in or based on observation or experience.
2. Relying on experience or observation alone often without due regard for system
3. Capable of being verified or disproved by observation or experiment.
Whether you are reading a financial newspaper or an analyst’s report empirical relationships are everywhere in finance. Our least favorite is regression analysis. The “Financial Graveyard” is filled with many a career using linear regression and least squares regression as the murder weapon. Financial relationships are sought, using regression analysis, money positioned to take advantage of this found relationship. Sometimes money is made and if predictable, big money moves in and poof. The relationship and the money are gone with everyone saying, “That shouldn’t have happened”. Or our favorite, “the move in the market that bankrupted us was 23 standard deviations away from normal!”
What makes EBVs – Economic Book Value’s so different?
EBV’s are built on structural equations. These equations do not change over time or across companies. These equations are part of a theory of how economic activity is related to the structure of an entity and how the economic process creates value.
Human beings cannot visualize trends in a column of numbers. We transpose these numbers into a graphical interface that viewers can easily see financial trends that can make an investor profits. We also make use of logarithmic price scale so viewers of our charts can observe compounding that takes place in any company that is growing.
We have designed our own charts to include logarithmic price scale and include a spectrum of lines call EBVs or Economic Book Values.
How are EBV lines useful to you as an investor?
1. As a user, let’s first consider the EBV lines themselves, without price bars and model price.
What are the EBV lines doing long term, short term? The reason we provide two charts is to give viewers prospective on the growth of the EBV lines. You can actually see the compounding of the numbers, assuming the positive slope of our multi-colored lines. If our EBV lines are flat, or trending down, tells the viewer that no growth has occurred or write-offs have occurred on the balance sheet.
Some questions we ask ourselves? Can we see the growth in the EBV lines and how steep are these lines? Steeper lines mean more compound growth. How consistent is this growth? Is growth accelerating or decelerating? We believe this is a faster and easier way of viewing what is happening with the financials of a company then looking at the actual numbers from the balance sheet.
2. EBV lines and overlay either a weekly or monthly price series.
Equity prices not only conform to EBV “zones” but also use EBV lines as support and resistance. Therefore we use weekly, and monthly price bars because they reveal more information of the interaction between price and the EBV lines themselves.
A company’s trading history usually confines’ itself to one or more “zones”. We call the space between each line a “zone” for practical reasons. Looking at our long term chart viewers can readily see which zone may seem comfortable for their given security. An observer will note that even with the growth in the EBV lines, prices will conform to a zone sometimes for decades. How and why does this happen? The easiest way of explaining this phenomenon is to point out the EBV “constants” that define our EBV lines come from observable forces in nature. Do known and observable forces in nature show up in the stock market? Absolutely. We are confident over time and use of model price charts you will be amazed, just as we are, how equity prices interact with our EBV lines.
When stock prices transition from one zone to another important information is being transmitted. Yes, we do occasionally say, “the market is speaking to you”. A “transit” signals a change of fundamentals is occurring, either positive (break up) or negative (break down). This can occur long before any signs and/or public announcement from the company itself. We admit transits can be tricky to trade, sometimes there are multiple break ups/downs of an EBV line before the market makes up its’ mind before the actual transit. This can be frustrating for a short-term trader, however when a transit does occur longer term traders can assess a very good predictor of the company’s investment performance long term.
3. Lastly, considering EBV lines, overlaying weekly/monthly price series with model price.
As we have said previously, our model price calculation is our calculation of ‘What the company is worth’. This can be of some help in determining which EBV zone the equity price should be trading. Observing the long-term chart can give you guidance on any discount/premium that may exist between our model price history and the zone the security feels comfortable. Also, any significant changes to model price, say change in earnings, can give advance notice on suspected transits in EBV zones in the future.
EBV lines and zones can give users considerable information with a blink of an eye. We are delivering two very important and new concepts to our users, model price and EBV lines, where one is just as important as the other. From blog to blog, we may emphasize one over the other however both are equally significant.
Also, we think it’s vital to point out the nature of our EBV lines. They come directly from the balance sheet of each company and are based on structural equations that are NOT trended or use regression analysis in any way. Yes, the same regression analysis, which has failed so many in the financial world.