What Is a Stock ‘Worth’?by
Sean Corrigan
The answer seems obvious: whatever someone is willing to pay for it, of course. But, it’s not as simple as that. For example, whenever we are obliged to determine the net asset value of our fund for the purpose of reporting to our shareholders, we take the last price bid for each security on the last day of the month; we multiply this by the size of our holding; we repeat the process for each security in turn; we add up the results and – lo! – we have an aggregate total. Though this methodology is standard throughout the industry, by virtue of its simplicity and transparency, we really ought not to forget that the price of the last traded fraction of the company’s stock is not logically applicable to the value of the whole. Here is the reason behind this assertion. “Dad, we are thirsty!” Imagine you are walking a baking hot stretch of beach, trailing your two restive and annoyingly insistent kids, each of them moaning that they are thirsty. Just ahead is the only kiosk visible for a mile or more in either direction so, gritting your, teeth you drag your little darlings over the last few hundred yards of scorching sand and there you happily part with $5 to get them a couple of small bottles of soda. Now, those two particular bottles, in that particular time and place, clearly seemed well worth $2.50 apiece in your hour of need. But, by the same token, you’d have been increasingly less keen pay such a premium for a third, a fourth, or a fifth bottle of what you’d soon have come to regard not so much as a welcome liquid pacifier, but as a fairly meager container of overpriced, sugary acid. Similarly, you’d also be a trifle reluctant to fork over that same $2.50 a pop when you’re cruising – thankfully child-free – along the beverages aisle of your local, air-conditioned supermarket – your shopping cart sandwiched between two long, closely-stacked ranks of competing wares. Again, at the neighborhood cash and carry, you may well be offered this same soda by the crateful. But, since you’ll have more urgent things to acquire with your last few bucks of housekeeping money than to buy three weeks’ advance supply of soda, it will have to be pretty steeply discounted to tempt you into making such a large purchase upfront. Taking this to an extreme, you’d be positively dismissive – even if you had the required wherewithal – if Coke itself tried to get you to take a whole year’s production from them at an equivalent price to the one being asked by that damnable seaside “gouger” (actually a man who is not so much a rip-off artist as an astute entrepreneur with a keen sense of what the local market will bear). So, we should quickly be able to deduce from this that it doesn’t makes sense to calculate the whole of Coke’s annual sales by taking the product of the waterfront kiosk’s circumstantially specific $2.50-a-bottle and the company’s 475 million bottles of worldwide shipments. But, if this is the case, we should realize it makes no more sense either to fall into the analogous trap of valuing all of Coke’s shares, en bloc, by taking the $42 where the last 4,000 lot changed hands and multiplying it by the whole 2.4 billion shares the company has in issue, to arrive at a market cap of $100.8 billion. The crucial point to grasp is that any individual trade reflects the monetary overlap in preferences of the most insistent buyer and the most willing seller at the point of exchange. It should be obvious that each individual will be influenced in where he ranks on that scale of mutual eagerness by plain circumstance. This is exactly in the manner that our two very insistent minors combined with the presence of only one nearby seller to make for a highly skewed deal at the seaside! Further, it is self-evident that as we begin to satisfy our appetite for what the other fellow has to offer, this quickly changes the relative attractiveness of the trade as we gain more of what we want – soda – and are therefore left with less of what we have to give up – money (and therefore the chance to buy, say, a candy bar for Mom, or a beer for Dad instead). Theoretically, the converse would apply to our vendor, who would gradually raise the price of each successive soda sold, were it not that he has no other, more pressing needs to satisfy with the money he earns and that he suffers severe constraints of time in shifting his stock-in-trade. Arguments along these lines were among those which revolutionized economic understanding in the 19th century under the guidance of the so-called “marginal utility” school, which included such Austrian luminaries Wieser, Menger, and Böhm-Bawerk. Churn and burn But, as well as this somewhat theoretical objection, there is a more practical aspect to the tyranny of the regular pricing mechanism to which we are subject. This is that most of these marginal buyers – the I-want-it-now, $2.50-a-bottle guys who effectively set the price for our snapshot of net asset value – are buying now, only to sell a moment later and they are doing this largely with borrowed money, into the bargain. To give some idea of the incredible rate of churn between specialists, brokers, and clients, consider that NYSE dollar volume has averaged $55 billion a day in 2005, while overall securities trading in the US topped $1 quadrillion (a one followed by fifteen zeroes!) in 2004. For equities themselves, however, data from the National Securities Clearing Corporation shows that, on any given day, typically as little as 2–3% of that sizeable notional sum actually goes to cash settlement – with the balance being netted out between all those frenzied intraday buyers and sellers, winners and losers. Thus, in a market dominated by players with the most restricted of short term horizons – who battle it out literally tic-by-tic for the scraps to be made between the brackets effectively set by the less frequent entry of punters taking a longer view – we can see that considerations of the actual fundamental value of any given enterprise are the furthest from the minds of the majority of those likely to set our reference price. What is a stock worth to these guys? Hopefully, a couple of tenths more than when they bought it two minutes ago. Moreover, even the longer-term players who impart the underlying momentum to the market – those who, as it were, provide the ocean current, rather than the tide which is superimposed upon it – may well be executing trades based on a whole host of disparate factors: technical analysis, “relative value,” “sector rotation,” “index arbitrage,” “asset allocation,” derivative or convertible arbitrage, and “black box” trading. The list of such blind, mechanistic, model-based approaches seems endless. As a particular case in point, on average, more than half – and anything up to three-quarters – of NYSE volume is now accounted for solely by program trading (Goldman, Sachs alone accounted in this way for 1.2 out of the total 8.8 billion of recorded volume in the week of June 24th). Yet another facet of this commoditization and temporal foreshortening of the market is the rise of the exchange-traded funds, or ETFs – quasi-mutual funds which “trade just like stocks.” As the latest hot thing to hit the Street, last year the assets incorporated in these entities soared by nearly one half, reaching $222 billion as everyone sought to cash in on the speculative fever of the times. Are these savings vehicles or tools of speculation? Are they a means to “grow the world economy by furthering the development of low-cost, efficient capital” (as the DTCC motto laughably proclaims) or merely another fancy way for respectable folks to do a little gambling with their nest-eggs? You tell us. But again, note that most of the people involved in trading this way – and so in setting a price on all the relevant securities – would be hard pushed to name the CEOs of the constituent companies, or their main line of business, or a single key product, much less tell you anything about their balance sheets or income statements. It should be apparent that the motivations of the overwhelming majority of “price-setters” are thus wholly different to the ones which drive us as we try to discharge our duty to our shareholders. In our work, what we are firstly seeking to avoid are costly mistakes of over-enthusiasm – of buying when the market is clearly overpricing a business. We try not to buy soda for $2.50, no matter how much the kids might whine at having to drink water instead. Conversely, we always try to recognize and take advantage of those times when the market underprices claims on valuable, well-managed, wealth-creating assets. 50 cents a litre? Yes, please. Do you deliver? By now it should be apparent that on both these counts – both the theoretical and the practical – that to focus too much on price, especially in the short term, is to commit what logicians call a “category error”: instantaneous market price and long-term value are decidedly not the same animal! Discounting the future But if a stock is not always “worth” the price, what factors should we consider in valuing a company? Here, many fall back on something called the “dividend discount” model, which effectively assumes a near infinite flow of dividend payments and discounts them back to a price payable today, using some readily observable long-term interest rate – usually, if highly inappropriately, in our view – the US Treasury 10-year note yield. This simplistic calculation, however, poses a number of problems, namely:
For our part, to the extent we pay any attention at all to this concept, we sometimes compare the market’s earnings yield to that applicable to 30-year BAA-rated corporate bonds – which, unlike US Treasuries, therefore theoretically discount for real yields, implied inflationary erosion, and corporate credit risk. This leaves us with a broad measure of expected real, long-term earnings growth. This, in turn, can be loosely benchmarked against observed or expected rates of change in gross domestic product with which, intuitively, it should be correlated over the long run. We should caution, however, that the only purpose for doing this is to judge how “cheap” stocks – as a group – may or may not be, relative to bonds, and not whether they – much less any individual components of the index they comprise – hold any absolute appeal whatsoever. Through the looking glass But what of the vexed issue of why anyone other than one of our market-timer friends would ever wish to buy a non-dividend bearing stock? What we can say here is as follows. A non-dividend paying, non-liquidated, still-independent stock derives its worth from a gauge of the company's ability (a) to generate real income (over some uncertain, but broadly-estimated time horizon) and (b) to maintain and hopefully to extend that income generation capability in the course of its operations (i.e. to preserve and accumulate 'wealth'). Essentially, this 'worth' reflects the fractional ownership of the firm's productive assets, its claims on resources; its inventories of finished goods; its stock of work-in-progress; and any other titles to property it holds, as well as to more ephemeral entities such as brand and reputation. Above all this, though, the stock has value as a vehicle through which to devote one's savings to a participation in that epitome of wealth generation – entrepreneurial activity, especially that of a kind in which one either is technically, or perhaps, financially unable to engage, alone and unaided. Granted, ownership of the stock must eventually release some of the income or the capital to its proprietors whether through dividends, buy-backs, spin-offs, liquidation, transfer sale, or take-over or there would be little purpose in owning it, beyond vanity. However, so long as one regards the potential for such deferred remuneration as reasonable and as long as one possesses the suitably low degree of time preference to wait, one need not demand such a disbursement in the here and now before considering the stock worthy of purchase today (particularly if one holds a realistically dark view of the process of the chronic monetary depreciation endemic to our modern system). To illustrate this, we ask you, would you have wanted Microsoft to have paid a dividend in the early, and rapid expansion days (at the possible cost of slowing its advance to profitable, global dominance)? Would you consider a share in the title to an undeveloped (and so, financially 'inert') gold-bearing ore as “worthless”? Moreover, for so long as the firm is deemed to be growing its shareholder equity better than any alternative is likely to do for a given degree of uncertainty which is a purely subjective matter, no dividends rationally should be paid; for to do so would actually be to squander and possibly to prejudice entirely the ultimately realizable worth of the company. Vive la différence To recap our earlier theme, it is critically important to try to maintain the distinction between this process of consciously and painstakingly estimating the true going-concern worth of a viable business enterprise and the one derived by a glib (and wholly non-marginalist!) extrapolation from the prices posted, second-by-second in the stock market, at which a handful of its shares are passing from largely instantaneous sellers to equally short-term buyers, the majority of whom are engaged in a frantic game of musical chairs, often after having borrowed the money for the entrance fee. As the example of Mr. Buffett, among others, underlines, significant returns can be had, often at relatively low risk, if one realizes that the two sums can diverge significantly – and can stay divergent for a considerable period of time. Indeed, the knack of recognizing this kind of disparity is what makes a great investor simply another form of entrepreneur (if a vicarious one) that is to say, a man who is constantly seeking to exploit the arbitrage between what he feels is the unduly depressed price of resources being made available to him and the total real income he will ultimately derive from their use.
July 14, 2005 Sean Corrigan [send him mail] is an executive of Sage Capital Zürich AG and strategist for the Edelweiss Fund. Copyright © 2005 Capital Zürich AG |
So,
what is a stock worth? The answer – different things to different
people – is not as trivial as it sounds, for in that very difference
lies a world of opportunity for those of us who know the only way
to protect our clients’ existing wealth – and then to nurture it – is by redeploying it at the most propitious moment so that it
can share in and help foster the creation of wealth anew by others.