By Keith Weiner – Re-Blogged From Silver Phoenix
We could also have entitled this essay How to Measure Your Own Capital Destruction. But this headline would not have set expectations correctly. As always, when looking at the phenomenon of a credit-fueled boom, the destruction does not occur when prices crash. It occurs while they’re rising. But people don’t realize it, then, because rising prices are a lot of fun. They don’t realize their losses until the crash. So we want to look at stocks when they’re high, before people realize what’s happened to them.
How do you value a stock? The classic methodology, proposed by Benjamin Graham and Warren Buffet, is to discount future free cash flows. Let’s leave aside the problem of how to predict future revenues much less cash flows in our crazy resonant system with positive feedback. For purposes of this discussion, we will just assume that a stock generates a known and constant cash flow of, say, $1 per year, in perpetuity.