First, they acknowledge that future cash flows will be better than they expected (or worse, if they reckon the security price will fall). To fine-tune that, it's the present value of the future cash flows that matters. So long as the interest rate used to express future cash flows in today's money values is 'correct' - although it's always a guess - the timing of the cash flows (this year, next year, 10 years' time) is neither here nor there.
Second, they acknowledge that the riskiness of the investment has changed; that it's lower if they think the security has become more valuable. In the trade jargon, investors will accept a lower 'risk premium'. As to the reasons, they may be due to internal or external factors - internal if, say, the merits of a company have changed so measurably that investors can be much more confident that future cash flows will materialise; external if, say, lower long-term interest rates justify a reduction in the interest rate component of the risk premium.
Like it or not, all movements in value distil down to changes in these two factors. Grasping this often helps clarify matters - especially when share prices are going haywire, when punters are breathless and when City analysts are lost in the details of a company's brilliant new product or service. It helps prompt a calm voice, which asks: OK, so what has really changed?
Which is a pertinent question to ask about Aim-traded Zytronic (ZYT), as its share price has been going doolally. In mid October the maker of the touch-sensitive screens that are ubiquitous in the modern world said results for the year to end-September would be "materially ahead" of City forecasts. Since then, its share price has risen 43 per cent to 434p. That's good because it makes Zytronic the top-performing holding in the Bearbull income portfolio in 2015. Even so, it's hard to spot that anything profound has changed at Zytronic or that exogenous factors mean the stock deserves a lower risk premium.
The superficially good news is that Zytronic traded well in 2014-15, generating a 7 per cent increase in the volume of units sold to 149,000, with a bias towards bigger screens, which yield higher gross profits. Combine that with good cost control and a 13 per cent rise in revenue to £21.3m fed through to a 39 per cent rise in operating profits to £4.55m. A higher tax charge trimmed growth to 26 per cent at the EPS level. Simultaneously, heavy capital spending - £1.38m compared with £0.59m the year before - absorbed extra cash, so Zytronic generated £3.48m free cash in the year, slightly less than the year before.
To the extent that capital spending will be deployed on projects that produce returns above the cost of capital, the extra capex adds to the value of Zytronic's equity. On average, however, Zytronic's capital spending is barely more than the depreciation it charges to write down existing fixed assets, meaning that it doesn't do enough capital spending to create much additional value; almost all its value is derived from what's already in place.
True, in reality it's not that simple. Zytronic may have unquantifiable assets with which it can create extra value and its directors certainly reckon the group has competitive advantages thanks to its patents and know-how. It may also be that these latest results - plus the confidence with which the directors face the current financial year - mean these advantages, which had been half hidden, are now widely recognised. In that case, a lower risk premium - adding value to the company - might be acceptable. Investors would accept lower investment returns in exchange for better chances that future profits will be higher and/or delivered more smoothly.
In practice, that's unlikely to have happened. One good year plus a bright outlook won't have such a profound effect on a business where the record remains a bit patchy. And, when I crunch updated numbers using average profits for the past five years as the driver, I find that there is maybe 10 per cent more value in the group than when I previously did the exercise six months ago, but no more. Nor can I justify a change in the required rate of return for holding the shares.
All of which indicates that what has really happened is that Zytronic's share price has run ahead of events by a greater distance than usual after a good set of figures. Therefore expect weakness in the coming months as investors - knowingly or not - contemplate the two profound factors with which we started. The investment lesson is, of course, generic. For me, however, there is a specific dilemma - should I sell shares in a company whose price is maybe 40 per cent above their intrinsic value?
