Brexit And Valuation Revisited
What are we to make of the market gyrations of the last week of June 2016?
The Dow Jones Industrial Average was down 868 points over the two days following the Brexit vote, causing a decline in wealth in the hundreds of billions of dollars collectively, and then up 828 points over the next four days, causing an increase in wealth of almost the same amount. The FTSE 100 – an index that tracks the 100 largest companies on the London Stock Exchange – erased its post-Brexit fall in just two days, enjoying its best day in five years and ending up at a two-month high. The VIX, a measure of fear in the market, shot up to 26 from 15, and then was back down to 15 only five days later.
These market reactions to Brexit make now a good time to remind ourselves of the function of the global financial markets, which is to try to value the future earning power of corporations all over the world. This valuation in turn is a function of the cash flows of these corporations, the expected future growth in these cash flows, and the required rate of return on these cash flows. The larger the cash flows, the higher the expected growth rate, and the greater certainty there is about these numbers, the higher the value the market will place on these companies.