I will start with a simple premise – global capital equity markets (“stock markets”) are discounting machines where intrinsic value is simply the net present value of expected future after tax cash flows. Said another way, the intrinsic value of a company’s share price is found by discounting the summed total future expected earnings (or free cash flows) by the cost of capital. For illustrative purposes we can look at a single stage discount model where we assume company free cash flow grows at a constant rate into perpetuity. In reality, this is largely an unrealistic assumption but useful to help form future stock market expectations.
Value of Stock today = Free Cash Flow tomorrow / (Cost of Equity Capital – Free Capital Growth Rate)
Most professional money managers and financial academics would agree with this premise, as Warren Buffet famously said, “In the short term the market is a popularity contest; in the long term it is a weighing machine.” So, though the stock market may act irrationally in the short run, our primary concern should be designing an asset allocation strategy that best serves your long-term 5% plus aggregate portfolio growth target while maintaining reasonable cash balances to tactically take advantage of market dislocations.