Financial theory cannot provideany direct answer tothese questions, but it canprovide a sound frameworkfor thinking about suchdecisions—not for just energy stocksbut for all stocks and even all investments.This framework is based onexpectations theory, which in simpleterms says that markets already reflectwhat is expected and respond to onlyunexpected changes.
Determine Stock Value
Economists agree that the price of astock should equal the present value ofall the cash (primarily dividends) thecompany can be expected to distributeto its shareholders in the next 50 or 75years. This is easy to understand andagree to if we drop the phrase "presentvalue" for a moment. If all you aregoing to get from an investment overthe long run is a total of $50, then youshould be willing to pay at most $50for it. Actually you should be willing topay much less than $50, because a dollarthat you expect to get in the futurethat has some uncertainties attached toit is worth much less than a dollar youwould pay today. That's where the"present value" phrase comes in.
Unfortunately, it is not easy to usethis theory to make investment decisions,because you have to estimatehow many dollars the company willdistribute in the future and also whatthose dollars are worth today. Still thetheory can be very useful in thinkingabout whether or not you should buy,hold, or sell energy stocks.
High Profits vs High Returns
Suppose you believe that the price ofoil will remain where it is today in thefuture on an inflation-adjusted basis. Ifthat holds true, then there is no questionthat companies like ExxonMobilwill make tons of money in the future.But that does not necessarily mean thatanyone who buys stocks of these companiesat today's prices will earnextraordinarily high returns.
What if the market also has thesame expectations about oil prices?The overwhelming evidence is that themarket is very good at anticipating thefuture and incorporating future expectationsinto today's stock prices. So theonly way you can expect to earnextraordinary high returns on energystocks or any other stock is by outguessingthe market about the future.Just guessing correctly that energyprices will go up is not enough eventhough most investors tend to basetheir decisions on that.
What makes the job even more difficultis that you do not know whatexpectations the market has alreadybuilt into the price of a stock. Forexample, you may believe that theprice of oil will rise to $100 and notjust remain at $70. Wouldn't thatmake ExxonMobil stock a great buy?Not necessarily. What if that is exactlywhat the market is anticipatingand has already built into the price ofthe stock? What it comes down to isthat the average investor can't possiblyknow everything that goes intothe price of the stock—and no onehas a crystal ball.
An interesting implication of thisargument is that if you are convincedthat the price of oil will rise from currentlevels and want to bet on it, youmay be better off investing directly inoil, natural gas, etc, instead of thestocks of energy companies. In thatcase, if you buy oil at $70 and it goesup to $100, you will make a large profitfor sure. And you won't need to puzzleabout the market's expectations. Ofcourse, if you are wrong and oil pricesgo down, you will have a large loss.Taking risk always has its downside.
Chandan Sengupta, author of The OnlyProven Road to Investment Success (JohnWiley; 2001) and Financial Modeling UsingExcel and VBA (John Wiley; 2004), currentlyteaches finance at the Fordham UniversityGraduate School of Business and consults with individualson financial planning and investment management. He welcomesquestions or comments at firstname.lastname@example.org.