Stock Price and Value

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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

Michael
S. Rozeff [send him mail]
is the Louis M. Jacobs Professor of Finance at University at Buffalo.

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