The price of a security reflects all available information. Practically, the price of a security is governed by the bid-ask spread that exists when people buy and sell it. The collective knowledge of the people buying and selling securities is what makes markets efficient. With that in mind, why was Twitter’s share price so volatile after its IPO, and why has its price appreciated so much if it hasn’t turned a profit?

The value of any asset stems from the cash flows generated by the asset, the lifespan of the asset, the expected growth in the cash flows, and the risk associated with the cash flows. In the case of Twitter, we are really only concerned with the expected growth rate in cash flows in perpetuity, and the associated risk.

So why has Twitter’s share price been so volatile? The price is based on the opinions and ideas that analysts, traders, and fund managers have regarding the company’s risk, and expected growth in future cash flows. The firm has not been changing, it is the excitement around the firm’s potential to generate cash flows in the future that has changed. This excitement changes as new information randomly develops which is what makes investing in individual companies such a gamble.

All predicting aside, it is still a dangerous game to speculate on growth. Even if this company increases its earnings dramatically and becomes a stable performer, the price has to increase relatively with the earnings to make this a good investment based on growth potential. As actual earnings increase, it is not likely that the price earnings ratio will increase in step; the price will remain stagnant, or grow at a fraction of the rate of the earnings because the present value of those future earnings are already priced in today.

It is fun to speculate, guess, and predict what the price of a stock will do, but people often confuse this speculation with investing. Investing is a systematic, scientific action that should not rely on any predictions of future events. Luckily for our clients, PWL understands the difference between predicting and investing and our scientific approach is present in every portfolio.