We have just lived through a stock market bubble and are now living through a housing market bubble. Inflation persistently erodes purchasing power. Consumers take on excessive debt. Bankruptcies reach record numbers. Plainly, many investors do not know how to handle their financial affairs. In fact, financial illiteracy has been headline news for at least a decade. The hapless investor has to run merely to keep up with the remarkable growth of new financial securities and markets in the past 35 years.
In my opinion, no investor can long preserve and grow capital without personally obtaining a sure knowledge of the investment world if not a knowledge of how to speculate. Even choosing a financial advisor requires a healthy dose of financial knowledge. Financial education is one very big challenge.
How does one tell when there is a bubble? Well, that's easy enough, we are told. The prices are driven far above the values of the assets. And what are these values? Where in the financial pages do we find them? Nowhere. What we often encounter is a confusing welter of terms used to describe the worth of a stock. We hear of business value, intrinsic value, going-concern value, private market value, fair value, long-term value, true value, book value, liquidating value, and of course that old standby, market value.
Let us begin to sort out this mess. It is not as bad as it seems.
A transaction price, the market price, is recorded when two parties openly trade in a market, say $25 a share for MSFT. With 10.8 billion shares of stock outstanding, the market capitalization of MSFT stock is $270 billion at that instant ($25 x 10.8b). This is also MSFT's market value.
Despite the fact that not all 10.8b shares have traded at $25, finding the total market cap in this way is sensible. The method is like valuing inventory. If a warehouse contains 1m cases of beer that sell for $20 a case, the inventory value is $20m. But the justification for this method applied to stocks goes deeper than analogy. It turns out that a great deal of MSFT stock can be bought and sold quite near its recent market price. Short-term traders who supply liquidity to the market help make this happen. For instance, in the past year, there have been 3 weeks in which MSFT traded almost 600 million shares or 120m per day, and in all three instances, the close-to-close market price changed by less than 1 point.
Of central significance is the fact that most stocks show reasonably similar behavior to MSFT. Quite a bit of stock can be bought or sold near the current price. In other words, when large blocks are placed on the market, if there is a price drop (which is usually quite modest), it happens when the market players infer that the seller has some private information. The size of the block itself does not exert much of an impact on the price. This means that investors generally can buy or sell very large amounts of stock near the prevalent market price if their transactions are not based on private information. Masulis and Shivakumar provide a technical study that supports these statements.
The bottom line is that (total) market value obtained by multiplying the market price times the shares outstanding is a meaningful calculation, even though the last trade only involved two traders, a buyer and a seller. That's good because many investors use these numbers in various ways, such as to distinguish small-cap, mid-cap, and large-cap stocks.
A quick example
Calculations of total market values can provide an investor with interesting data to interpret. The following is not a stock recommendation! I spent exactly 2 minutes getting the data and I know nothing about these companies. I merely wish to make the point that aggregate valuations can usefully stimulate one's investment thought processes. So here goes. Google (GOOG) and Yahoo (YHOO) together have total equity market capitalization of about $135 billion. Their sales add up to $7.8b. Their profitability is such that the net income on these sales add up to $1.65b. Meanwhile PG has a total market cap of $136 billion, sales of $55.5b and net income of 7.0b.
These comparisons make you wonder why PG, which is making 4 times as much as GOOG and YHOO, has the same market cap as those two companies combined. The answer is that the growth of GOOG and YHOO has been much higher than PG's, and the market cap reflects an anticipation of high continued growth. Before you decide to arbitrage these stocks by buying PG and shorting YHOO and GOOG, one factor to consider is what growth rate the market has built into the existing prices, whether your forecast of growth is more or less than the market's, and the future dates when you the shareholder can expect the free cash flows produced by this growth to appear. (Right now PG has a free cash flow of over $22b that dwarfs those of YHOO and GOOG.) There are other important factors to consider as well, such as detailed analysis of the price/volume behavior of these stocks (that's my opinion.)
The above superficial and incomplete glance at 3 stocks is not a security analysis or a recommendation.
Portfolio market value
We also use market values of individual stocks to find the market values of portfolios or baskets of different stocks. To a very close approximation, the market value of a portfolio equals the sum of the market values of the stocks in the portfolio. It has to or else riskless arbitrage profits would be available. I'll skip the details, which are lengthy. Instead, you can rely on your intuition that a grocery bag containing a carton of milk plus a box of corn flakes has about the same price as buying the milk and corn flakes separately (a number of other things held equal.) Or perhaps it seems obvious that if $150 worth of IBM is placed into a portfolio along with $90 worth of Dupont, the overall portfolio is worth $240.
Calculations like these go into the calculation of mutual fund net asset values that investors eagerly check each day. The fund finds the total market values of all the assets it holds, subtracts the total market values of what it owes, and the result is total net asset value. That's $240 in this case. If 10 shares have been issued against these assets, then net asset value per share is $24.
Value vs. price
To avoid confusion, we need to distinguish price and value. Price is what it costs to purchase the stock. Value is a subjective number that anyone can assign to the stock. Price is objectively observed in the market by all. There can be as many valuations attached to the stock as there are people willing to make them, but there is only one last trade price and one current quote.
The market of all investors is like a composite person that aggregates everyone's opinion about a stock. Warren Buffett refers to Mr. Market, and this is a fine way to conceptualize it. Mr. Market is special because he is everyone taken together. And for him and him only, something special happens: Mr. Market's total capitalization for MSFT of $270b is also Mr. Market's valuation for MSFT. Or Mr. Market's market price per share = Mr. Market's market value per share. More tersely, market price = market value for any stock.
I will explain. Even though Mr. Market's valuation is computed from the very last trade that just occurred between only two traders, it is still the entire market's valuation. This is because all other traders that might have traded have chosen not to. They let that last price stand when they did not trade. They accepted it. If they really believed the price was too low, they'd be in there buying. So, only for Mr. Market (and those who agree with his valuation) does value = price.
To understand the distinction between market price and value for investors other than Mr. Market, imagine that there is something called the "true value" of MSFT. No one knows what it is and no one can observe it. To find it would be prohibitively costly, meaning it simply could not be done. (This is an aspect of how little we know.) This true value depends on the dollars to be returned to the shareholders over the indefinite future, when they will be returned, and at what rates of return they are discounted to present value. But the fortunes of MSFT in the future depend on decisions of people in the future, billions of these decisions, about what they buy and sell, what they produce, what new competing products appear, what labor-saving devices appear, what taxes are, what wars happen, ad infinitum. It is impossible to know the true value of MSFT.
Mr. Market's market valuation of a stock is an estimate, an informed judgment, of what this true value is. This does not mean that Mr. Market has given a correct, perfect or good valuation. He doesn't know the true value, so he could be wrong and very wrong. Now think about individual investors. If they accept Mr. Market's verdict, then they agree that his value is the market price. But they can think that Mr. Market is wrong. Some can believe that MSFT's value is $19, below its price of $25. They are bears on the stock. Others can estimate that MSFT's value is $30 and be bulls on the stock. Individual opinions can differ from Mr. Market's valuation.
Many of the terms mentioned at the outset have to do with valuations made by individuals who may disagree with the market's assessment. Their estimates of true value are called variously business value, intrinsic value, going-concern value, fair value and long-term value.
Many years of finance research suggest that Mr. Market's valuation is hard to beat consistently. Sometimes his judgment is too low and sometimes too high, but much of the time it is hard to know which way he is erring. Mr. Market's valuation of a stock is not to be taken lightly, even when you disagree with it and speculate against it, inasmuch as it provides the outcome by all of the bears and bulls using all the methods and information at their disposal. It represents the outcome of every trade by anyone for any reason. It may be wrong, but the merely average investing performance of most institutional investors suggests that it is by no means an easy task to figure out whether the price is currently too low or too high and whether or not it will move toward your personal valuation over a time span that provides you with a profit on a speculation. Like any entrepreneurial activity, making value estimates profitably has a high failure rate.
Understanding price vs. value allows us to see that there are basically two ways to invest in stocks. One way is to be passive, accept the market prices as your values, do not try to beat the markets, do not speculate. Rather, buy a highly diversified portfolio that suits your tastes for risk and your tax position. This way basically accepts Mr. Market's valuations. The second way is to be active, take a different view of value than the market's, try to beat the market, speculate, focus on a few issues or on other strategies that promise high returns to compensate you for your risk, time, etc.
Most people are best off sticking to passive investing. Active investing has many costs. Trading in and out incurs brokerage costs and taxes. Traders buy at the ask and sell at the bid quite often, and the ask is higher than the bid. That's another cost. Trades have an impact cost too if other players judge them to reflect information about the existing stock price. And any buyer or seller who is not careful in the way that the order is placed and executed can get nicked by an amount that hurts. Then there are costs of research and managing the portfolio.
The issue here is what works and what doesn't to make speculative profits. The proof is in the pudding. Buying into the active strategies that financial advisors are peddling amounts to an active strategy itself! It requires a good deal of costly investigation to evaluate these advisors. Generally, one should be skeptical about claims of marked success in active investing.
But if you have an entrepreneurial streak and wish to work out a strategy, there is nothing to stop you. Some of my students have looked into technical analysis with promising results, for example. Although active strategies have an uphill battle to make profits, they involve entrepreneurial activity and some succeed. Look at Warren Buffett.
July 23, 2005
