Stock Market - Market Valuation or Gambler's Odds

One of the basic principles of economics is that the price of a commodity will (in a free market) stabilize at an equilibrium at which the price that sellers are willing to sell meets the price that buyers are willing to buy. In this sense, the going price for the commodity may be viewed as a valuation of that quantity - the market forces have determined that this commodity represents this particular value. My question concerns stock prices, and my suggestion is that they do not represent an assessment that the stock is worth any particular price, but rather an assessment of the likely direction that they will take relative to the current price. This is due to the fact that very few people purchasing stock have any actual use for the stock, and are merely purchasing with the intention of ultimately reselling it. In the case, it would seem that the actual price is merely the accidental intersection of buying and selling pressure, and not much more. New buyers or sellers will take the current price as a given, and make a judgement primarily on prospects for the stock doing better or worse than it is now - no judgement of the current price is necessarily being made at all.

Now it is true that in cases of stocks that are egregiously over or undervalued, there will be a corrective adjustment made. This is due to the fact that the under or overvaluing will in such instances be themselves interpreted as evidence with regard to future stock movement relative to today. Simply put, the trader will buy or sell them thinking himself to be ahead of a curve which will follow when others catch on. Not due to the fact that he is getting a specific value today. I would suggest that this will manifest itself at extreme levels, but that there may be a large zone in which the price can fluctuate independent of such considerations.

This question is somewhat theoretical, but it does have practical considerations as well. In fact the inspiration for the question is a particular stock in which I have a position. This stock had been undergoing a slow but steady rise since the beginning of the year, but suddenly increased by about 75% over the course of the last week. This correlates with the fact that an investment fund controlled by Merrill Lynch has been steadily increasing its position in the stock over this time. At some point this added buying pressure will be removed, and the question is what happens next?

I see two scenarios, dependent on the question here. 1, it drifts back down until it hits the trajectory that it would have been on absent the temporary manipulation. Or 2, it reverts to the old trajectory, but uses the current value as the new starting point. (All this absent other considerations of course). This is dependent on the question raised above. If any given price can be regarded as a valuation by the market at that price then one could expect the stock to revert back to this price once the temporary price manipulation passes. But if only buying or selling pressure count, then the new price is as valid as the old one, and one would expect this price to become the new starting point for the pressure.

(Note to the moderators - I am not quite sure if this belongs in GD or GQ. I would imagine that this would depend on whether this topic has been dealt with by economists and stock market theorists. Feel free you move it as you see fit. Also, I’m not asking for advice in my specific instance, which is complicated by numerous other factors, but have used this example purely for illustrative purposes.)


Two things. 1. The “Irish law” of finance markets: if something is going to go up, it’s gone up already.

If you didn’t own it, would you buy it (ignoring transaction costs)? If not, take yout gains or losses. Bygones are bygones.

Otherwise your thinking seems pretty smart, except

seems to me to contain a contradiction.

First, a clarification. I think that what you are questioning is the value of equities, otherwise known as shares. Stock refers to corporate and government loan capital and its pricing tends to be much duller. I’ll cover the pricing of loan stock too if you want, but let’s start with equities since they seem to cause the most confusion.

Actually Izzy you’re wrong to say that the majority of shares are held by people looking to make a quick buck off of a change in its price. Over 70% of shares are held by pension schemes and in life assurance vehicles. These investors are in it for the long haul and in general look to buy shares that are good value. But what is good value?

Well, the fundamental value of an equity is the present value of the dividends you expect to receive from it, where present value allows for the effect of interest. To get mathematical, the fundamental value of the share is

V = Dg(t[sub]1[/sub])/i(t[sub]1[/sub]) + Dg(t[sub]2[/sub])/i(t[sub]2[/sub]) + …

V is the fundamental value of the share
D is the dividend now
g(t[sub]n[/sub]) is the growth in dividend to time t[sub]n[/sub]
i(t[sub]n[/sub]) is the valuation rate of interest to time t[sub]n[/sub]

If we make the simplifying assumptions that g and i will remain uniform (this is where it starts getting unrealistic - real-life valuers will not make this assumption, but it serves for illustration), then this simplifies to

V = D(1+g)/(1+i) + D((1+g)/(1+i))^2 + …

= D(1+g)/(i-g)

  • a rather nice simple equation! In theory the market prices for the share should be the market concensus as to what V is. Note that it depends heavily on your assumptions for i and g. This gives you the reason that share prices shift so much - every time evidence is available (or more to the point perceived evidence) that i or g are not what we originally thought, V changes. In particular, small changes in i - g will have large effects (plug in some numbers and see for yourself).

The assumption for g will come from the concensus view as to the likely growth of the company. This in particular is subject to subjective viewpoints.

Of course there is more to sharepricing than fundamental analysis, but it gives you a nice flavour as to how the experts think. The brighter amongst you will have noted that some companies have no dividends (think companies). In this case fundamental share pricing still kinda works because the shares have value due to expected future dividends - you just have to go back to the original equation and substitute the expected future dividends for the generic growth dividends. But really dot.coms are an example of where hysteria can overcome logical pricing. One professor suggested that their price should be V[sub]t[/sub] = 1.1 * V[sub]t - 1 week[/sub]!

Which leads me to the other great driver of share prices - index-tracking. Many fund managers are forced to buy and sell shares to keep their tracking errors to a minimum. This means that when a share enters the index its price will surge as all the trackers are forced to buy it and vice versa if it drops out of the index. Feh.


picmr - you are referring to what is known as technical analysis, or chartism - the peculiar practice of attempting to predict share movements by studying past patterns. The justification is that the past tends to repeat itself. The trouble for the layman is that[ul][li]Sometimes what goes up goes up higher… but…Sometimes it goes down instead![/ul]Chartists attempt to work out which it will by finding past situations that are close.[/li]
Opinion is divided on technical analysis. It was certainly popular in the 80s but almost died in the 90s. It still goes on quite a bit in the US but AFAIK only one investment manager uses it in the UK - and they have a US parent. In all cases however its use is almost exclusively to back up the fundamental analysis - it is virtually never used as the driver of decisions, let alone by itself.


Actually kabbes I meant to refer to the weak form of the efficent markets hypothesis.


As mentioned, I used the example for illustrative purposes. The actual case is complicated by long term considerations and other complicating factors.

Perhaps you might expand on this. It seems straightforward to me. Say the price is $34 a share. You believe that the stock is well managed and has great prospects etc. You believe that changes to the economy will bring this type of business to great prominence. So you determine that it is likely increase. Does this represent a judgement that the $34 is correct absent the future growth factors that you believe in? I would think not. It’s only your determination of what will happen in the future relative to today. You are accepting $34 as the starting point.


I don’t think you are correct in the distinction that you are making between long and short term investors, for purposes of this issue. (I’m not saying that the majority of shares are held by people looking to make a quick buck off of a change in its price" - I was thinking of emphasizing this in the OP, but thought it was obvious). Short term investors think the stock will go up in the short term - long term investors think it will go up in the long term. Neither are intending to do anything other than sell the stock ultimately.

I also disagree with your point about dividends. For many companies the actual dividend is non-existent, as you note, and even for those that issue them, their pricing values the theoretical aspects as well. (For a further discussion of this aspect of stock prices see this thread.) In light of this, I don’t see the relevence of this method of calculating value to this thread.

Fair enough picmr - but

is definitely the thin end of chartism!

Well Izzy I’m afraid that if you believe that most shares are bought purely with an eye to selling them again you are wrong. That would be far too esoteric and nebulous an investment decision, requiring a far higher risk premium than shares offer. I’m also sorry you “disagree with [my] point about dividends” (although I’d hope that a mathematical derivation was more than merely a “point”), but unlike picmr IAAFG and this is how it works, albeit much more complicated.

Look - share pricing is complicated. I’m not going to deny it. But the outline I’ve given is the basis for fund managers’ decisions as to whether a share is good value or not. Ultimately the share is worth no more than the value of its dividends. And you seem to have totally ignored my point about dividendless shares - they are worth something because they are expected to reap dividends in the future! and for no other reason. If they were not then the share would be worthless and its value would quickly plunge to zero. As for saying that “most” companies do not issue dividends… I’m speechless!

This was the meat of the OP question:

Well that is mostly incorrect. The equity’s price is merely the market consensus as to the future value of the company. You do your analysis and if you think that the share is undervalued relative to its dividends then it is a good buy, otherwise it is a bad buy. Shares do however occassionally become flavour of the month or stink of the week - in this case fundamental analysis will break down and the price will shoot too high or low. Technical analysis seeks to predict this. However ultimately the price will return to the consensus view of the future value of profits. 'Cos that’s all a share is.


I did not ignore it - I linked you to another thread where several posters - including myself - discussed this very issue. But perhaps you ignored the link

Well in that case you may begin talking once more, in light of the fact that I’ve said no such thing. What might have confused you was my assertion that even in companies that actually issue dividends there is no direct corrolation between dividend amount and stock (or share - whatever) price. This is due to the fact that in addition to the actual dividends, theoretical dividends are also being valued.

I find this hard to believe. I am inclined to think that the significance of being undervalued is in the idea that once the rest of the world figures out what you know the stock price will rise.

What manner of financial guru are you? (I seem to recall that you are an actuary).

Hmmmm…maybe I’m thick, but you seem to be saying the same thing. Or is it the difference between future dividends and future price? What Kabbes is arguing is that these (given a perfect market) would be the same.

Kabbes: I think “if something is going to go up, it’s gone up already” means that expected future value is already built in to present value. So if everyone thinks Macrohard is going to go up in the future, they’ve already bought it so it’s already gone up. So the current price already includes consensus estimates of future growth.

That seems to be the crux of the issue. I suspect that the market is subject to buying and selling pressure which move the price independently of mathematical calculations of future dividends (or more acurately earnings). I suspect that kabbes’ is describing the theoretical underlying value of the market, but that it is not correct as a practical matter.

I’m unclear to what in this thread you are referring to. But I believe the theory that you outline is known as the theory of the Efficient Market, by a guy named (IIRC) Burton Malkiel.

A question for kabbes: shouldn’t that be future earnings and not future dividends you’re talking about? And if not, why not?
After all, Digital Equipment never paid a dividend, right up until the day that Compaq bought them. Which is the point: the company’s assets had value, regardless of whether or not the company paid dividends. It was DEC’s stated policy not to pay a dividend, by the way, so everybody who bought that stock bought it in the knowledge that no dividend was to be expected.

yeah - actuary. For those who need to know, I deal quite a lot with pension scheme investments and meet with financial managers who have to justify their decisions to us. I don’t have to make those decisions myself, so my views are not necessarily those of people with their fingers on the actual button, but I have (professionally) studied the theory and do have month-to-month if not day-to-day dealings with those decisions. By the nature of these things too, if I spend a day in an investment manager’s office I’ll end up chatting with those there about the current state of play in the markets and their views about various shares. I’m pretty confindent that things work much as I indicate.

Incidentally, it is quite interesting to see the extent to which investment managers DO scope out individual companies’ dividend potential. One guy whose current responsibility was non-UK Euro consumer goods shares told me that he had just been to a fashion show to check out the latest lines for various companies. This was an attempt to gauge how the lines would be received by the public and therefore how that company would perform next year!

With that in mind - having reread the thread I’m not sure there is that much disagreement here anyway. Ultimate decisions on whether to buy a share or not depend on many factors and it seems that we’ve all just chosen a different factor to shout about. The fundamental value is only one factor in the decision, but it is a pretty important one.

The fundamental value of a share is as described. For most shares most of the time the value pretty much follows the share’s earnings potential. On special occasions, such as the entry of a share into an index, rumours of takeovers and so forth, as well as the occasional piece of bizarre mob mentality, the price deviates (potentially significantly) from its fundamental price. If it deviates far enough then many managers will buy it, knowing that it’ll return eventually. However sometimes they won’t because they suspect that the trend will continue.

As for the efficient market hypothesis - depends what market. Apparently the non-UK Euro and developing world markets in particular show few signs of being efficient. UK and US are much more so. In general the views of the future ought indeed to be built into the price, but remember that the price is only a consensus of those views. There is plenty of room for an individual to take a position on that consensus.

pantom - you’re talking here about a takeover and that’s a whole 'nother ball game than an investor seeking to expose themselves to a company. If you seeking to own or substantially own a company then you are interested in the earnings potential of that company. You gain representation on that company’s board and can influence its direction. The share purachase in that case is a means to an end rather than the end in itself. If, on the other hand, you just want to invest in a few shares then the value of those shares is just the value of the shares’ future earnings potential - i.e. their dividends. There is a material difference in intent.

Izzy - apologies. You didn’t say that most companies don’t give dividends. You did however say

  • which I also take exception to. A tiny tiny minority of companies pay no dividends. And all companies expect to pay dividends at some point - else what’s the point in being a company?

And now for something completely different:

Yet more share pricing methods

I’ll throw another equation into the mix - Hopefully, small rounding errors aside, this should be fairly intuitive:

y = d + c

where y = total yield on share
d = dividend yield (current dividend divided by current price)
c = capital growth

However if you assume that the share is correctly priced (i.e. fundamentally priced) you could also say that y = d + g where g = dividend gowth. This incidentally would imply that g = c.

Note however that we also have

y = i + r + erp

where i = expected future inflation, r = real yield on a risk-free asset (i.e. government bond) and erp = equity risk premium. The erp is to compensate the investor for the risk of default on the share and its relative lack of marketability. Hopefully this equation too is intuitive - think of it as defining the erp.

Put 'em together and you have d + g = i + r + erp

This means that if you have an expectation of future inflation and a required real yield (or these two added together, which kind of gives you the yield on a fixed interest bond, which you can look up) you can merely add your required erp (determined by inspecting the company) to get your required yield. You know d (current dividend divided by current price), so you can derive the market’s expectation of g (with respect to your erp). If this is lower than your expected g then go ahead and buy, else sell.

I’m not sure how clear that is to those without any financial training. Could I get some feedback if you don’t understand and if necessary I’ll spell it out a little more. Apologies if this post is less coherent than usual - I’m a bit rushed at the mo!


kabbes: First off, thanks for all the info. Secondly, I think we may actually have a cultural diff here between your country and the U.S.
After reading your reply to IzzyR, I went over to Yahoo to look at my page of stocks I keep there to follow their quotes. Going down the list, there were 24 stocks altogether, with 7 who didn’t pay a dividend, making for a total of 29% in this random sample of companies. IMO this universe of stocks is actually less risky than those followed by other typical individual investors, 'though more risky than the typical universe of stocks followed by a professional money manager, I’m sure.
Over here, dividends are taxed as ordinary income, all the way up to 39.6%, whereas capital gains top out at 20%, I believe. (Someone correct me if I’m wrong.) Are they taxed in the UK, and if so, at what rate? Anyway, I think people here are apt to almost penalize stocks that pay a lot of dividends for this reason.

Hmm… pantom that’s interesting. I’m not too sure what to say to that 'cos from my cultural viewpoint if a share doesn’t actually pay anything out then it isn’t fundamentally worth anything! If you are totally relying on capital gain to make your money then the whole system really is built purely on investor confidence and could collapse at any time.

Not that I’m saying you are wrong, but I do slightly question your sampling technique however. Presumably you had those shares bookmarked because they interested you - that means that the nature of those shares aren’t independent (they share the “appeals to pantom” characteristic). Also are you sure that it is the case that they don’t pay dividends at all instead of the possibility that they merely haven’t yet paid them in your timeframe or indeed merely that economic circumstances have led them to not declare just this year?

Either way, for your own info in the UK we do tax dividends as normal income whilst capital gains has its own class of tax. Individual investors have an untaxed capital gains allowance which is separate and more generous than the untaxed income allowance is, meaning that to most people capital gains are preferable to income - however AFAIK capital gains are taxed at the same rate as the investor’s income past the allowance.

Corporate tax, trust tax and pension scheme tax rates are all different again and as you can imagine even that which I know is more complicated than I can reproduce here. You can say that the general theme is that capital gains are preferable - but there are some situations that this doesn’t apply.


Actually, I agree with you on that, (one need only look at the recent bust in the dot-coms to see what happens), and I actually do look for companies that pay dividends, despite the sample of stocks on my Yahoo page. Also, I look for companies with little or no debt.
But over here I don’t think I’ve ever heard an analyst say that he’s recommending a stock because of the prospect for increased dividends. They cite price/earnings, price/sales, or EBITDA (Earnings Before Interest, Taxes, Debt and Amortization), or break-up value, or some other “fundamental” criterion, or they’re technical analysts looking at mere momentum. There are some funds out there that do look at dividends in their investment policies, but these are specialized funds; the vast majority of funds don’t really seem to care.
For instance, this week’s Barron’s had an article re Federated Dept Stores (they own Bloomingdale’s and Macy’s), a stock which as far as I know has never paid a dividend. (I did a quick search on Yahoo for dividends from 1990 to the present, and it came back with “No Dividends in this date range”, which also answers, for at least this one stock, the timeframe question.) But they were recommended on the basis of being a company with low debt (I track it on my Yahoo page partially for this reason) with good prospects for an increase in earnings (as defined by the above EBITDA). Nowhere in the article was any concern expressed about the fact that they pay no dividend, and don’t seem to have any plans for doing so at any point in the future.
As far as I can tell, the one thing it does affect is the stability of the stock price, with dividend-paying stocks being significantly more stable than those that don’t, doubtlessly for the reason you cite in the quote above.

Back to taxes: it’s interesting that you say that cap gains are treated favorably in the UK as well. Over here the Republicans are constantly complaining about double-taxation of corporate earnings, where it’s taxed once on the level of the corporation’s income tax return, and again if they pay out a dividend to their shareholders as income on the individual’s income tax return. Is that true there as well? I ask because one of the things I’ve heard the Republicans allege is that this double-taxation is true only here in the U.S. (It’s a hijack, I know, but I’m curious.)

BTW, I should make it clear that I try to look for companies with low debt to control for the fact that they may not pay a dividend; it helps my “confidence” level somewhat. :slight_smile:

Yeargh - corporate tax. Now IANAAccountant, but as at a couple of years ago when I learned about this stuff it worked something like as follows. Warning: this is from memory and I’ve never needed the exact knowledge before, so read with caution.

Company pays corporate tax. Company pays dividend out of post-tax profit. Receiver of dividend also receives tax credit with dividend. Dividendee (to coin a phrase) can claim some tax back in a complicated way depending on their tax bracket compared to corporate tax rate. Company receives ACT (advanced corporate tax) credit. Company can offset total corporate tax against ACT in something like a 10 year timeframe, so the ACT acts as a smoothing mechanism.

Now I’m fairly sure that some of the above is going to be wrong and that I’ve forgotten some important points. I’ll look the proper answer up when I get home tonight and give you a better answer tomorrow.