Financial Mathematics Text

Friday, May 30, 2014

Misnomers in Finance

You know what really grinds my gears1. . .

                                                                 . . . misnomers in finance.

Essentially there is some technical jargon that I think was inappropriately named. Here are a couple of examples.

Intrinsic Value - Stocks

So I consider myself a "value investor" of sorts and so owe this and that to Benjamin Graham. In spite of that, (and I don't know if he was the first to use the term in this way) Graham uses the term intrinsic value to refer to the value of the stock. But before getting into that, let's take a brief detour through the difference between "intrinsic" and "extrinsic".

Intrinsic vs Extrinsic

Here the Wikipedia article does a decent job of making the distinction:
An intrinsic property is a property that an object or a thing has of itself, independently of other things, including its context. An extrinsic (or relational) property is a property that depends on a thing's relationship with other things. For example, mass is an intrinsic property of any physical object, whereas weight is an extrinsic property that varies depending on the strength of the gravitational field in which the respective object is placed.
There's one thing that's important to emphasize here: extrinsic properties depend on the thing's relationship with other things.

The Intrinsic Value of a Stock

So what is the "intrinsic value" of a stock?

The simplest answer to that question is all future dividends discounted to the present. Sometimes "cash flows" are used in its place.

But let's not focus too much on the details here. What's important is that the "intrinsic value" of a stock depends upon a discount rate. That discount rate depends on prevailing interest rates.

And the salient point here is that prevailing interest rates are not intrinsic to a stock. Hence, the value depends upon its relationship to "other things" and is therefore extrinsic not intrinsic.

So calling the stock's value "intrinsic" is a bit of misnomer.

I would suggest we call it something like fundamental value or present value or something like that.

Intrinsic Value - Options

So if the above isn't bad enough, the finance folks decided that the word "intrinsic" should also apply to derivatives.

What's meant by intrinsic value, and I'll use a call option as an example, is that the option gives one the right, but not obligation, to buy shares of stock (or whatever the underlying asset is) at a specific price called the strike price. If the stock is selling at a higher price than the strike price, we call the difference the intrinsic value of the option. If it's not then the "intrinsic value" is \$0.

So what's the problem here? We only have to take a look at the definition of a derivative to see (from Investopedia):
A security whose price is dependent upon or derived from one or more underlying assets.
So if the value of the derivative is dependent upon or derived from some other assets is that value intrinsic or extrinsic? (see definition above).

A derivative, by definition, can't have intrinsic value since its value entirely depends on the value of some other asset.

But we still want a name for this feature of options so I would suggest something like exercise value. In other words if I were to exercise my option and close out the position that's how much cash I'd put in my pocket and that's what we'll call exercise value.

Consensus Estimate

Etymologically speaking, the word consensus comes from the Latin for "agreement, accord". Per Merriam-Websters, it refers to "general agreement" or "group solidarity".

In finance, it means something entirely different. Per Investopedia, a consensus estimate is a "figure based on the combined estimates of the analysts covering a public company." This figure is typically an average.

So ten analysts all attempt to estimate what earnings for a company will be. They each come up with their own estimate. In all likelihood, these estimates will all be different, hence, there is not "general agreement" or "group solidarity". We can then take all of these estimates and calculate an average of them.

So here's a crazy thought; let's call this figure the average estimate. Because it sure as hell is not a consensus!

And while we're on the topic of average estimates, the other thing that grinds my gears is when they talk about companies beating (or failing to beat) estimates. This would make perfect sense if these were goals (e.g. company XYZ beat or failed to beat its goal for the year.)

But they're not goals! They're estimates! If the company beats its estimate, then the analyst got it wrong! The analyst is making a prediction and we test the prediction against reality; we don't test reality against the prediction.

So those are a couple examples of misnomers in finance.

1 Yes, this is a Family Guy reference.

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