In the short term, stock prices follow a simplified model of the law of supply and demand. People trade stocks based on their expectations of future performance and assumptions of other traders’ actions, hoping to buy low and sell high (Just getting the obvious out of the way before the OP…)
I also remember my Micro-101 teacher saying that stock prices represent the long-term profitability of a company.
Why?
To have causation, there has to be one or more checks on the price of a stock. Gross overvaluation of a stock would be checked by the fact that if a company goes under, you are stuck with part of it and will have to either settle for your share (if any) from the liquidation auction or else make room in the living room for the widget press that represents your share of the company (I’m kidding, but you get the point.)
I’ve tried to think of how undervaluation might be checked, but the only means that I could think of is a company buyback of the stock, which, as far as I see, would not benefit the company and I believe would have to be approved by the shareholders. Sure, if a stock couldn’t be sold otherwise, the shareholders would jump at the chance to unload, but both the threat of bankruptcy and the buyback idea (if it exists, and no, I don’t want to give it the dignity that calling it a theory would give) appear to be very loose controls on stock price.
So, that said, what keeps stock prices linked to reality? Besides the threat of bankruptcy, are there any other links between a company’s performance and it’s value, or is everything else left to the analysis and assumptions of those who trade in its stock?
I’d appreciate any explanation you folks might be able to give for this. I’ve wondered about this one for quite a while. I’ve asked my friends who have more trading experience than I have, but they all drew blanks on this one.
We’re having a jolly old time arguing about this in this thread in Great Debates. It’s my argument that nothing keeps share prices tied to reality, necessarily, at all. People will usually pay more for a profitable company, but they don’t have to - witness all the internet companies that have never turned a profit in their histories but whose stocks are selling like gangbusters.
It’s a complex issue. The price of the stock is based on the perception of supply and demand. If people think a stock is a good one, they buy it and run up the price. Often, performance determines the value of the stock. However, investors are not logical machines and develop various manias (internet stocks, for instance) and have to own certain issues. Eventually, enough come to their senses and the stock price drops, but that often brings a counterreaction, making the stock undervalued.
A lot about the stock market makes no logical sense. Take technical stock analysis, for instance, where where whether to buy a stock or not is determined by the pattern of sales. One thing they look for is a “head and shoulders” pattern – sort of a bell curve. This is supposed to be a sign to buy, but if you map out the digits of pi on a graph, you get this pattern a couple of times.
Or look at the Wall Street Journal, which asks experts the pick stock and compares their results versus throwing darts at the financial section. The darts do as well as some of the experts.
The stock market is, mathematically, a chaotic system.
Stock prices, when all is said and done, are simply a function of supply and demand. One has to remember that, as far as the company itself it concerned, the stock price is important ONLY under certain circumstances, namely when they wish to use it as currency for acquisition or possibly when they wish to sell some treasury stock to raise capital. It matters a lot to shareholders (including employees with stock options, etc.), but a company’s balance sheet does not change with the price of its stock.
One way to demonstrate the supply-and-demand aspect of stock prices to examine stock volatilty vs. the “float”, i.e., the number of shares of stock available to be bought and sold. Companies with lower float are more volatile (although not necessarily more valuable) because there are fewer shares available for trading.
“Stock prices are opinions” (I’ve heard this several times)and
“When the shoeshine boy starts giving me stock advice, it’s time to get out” Dale Carnegie, 1927
Everyone seems to be tackling the deeper questions about a stock’s value, but haven’t yet addressed the first-pass, simple answer, which is what the OP asked.
What keeps a stock price tied to reality is the fact that they pay dividends. A stock’s price, in theory, should be the same as the present value of all the future dividends the market expects the company to pay.
If the stock’s price is higher than this, then it is attributable to the tulip-bulb effect, which is basically a Ponzi scheme.
I doubt if you will find a fairly valued stock on the market by this measure. Even GM and T currently have dividend yields of under 3%. And many issues of well known companies, particularly tech sector stocks, don’t pay dividends. MSFT, CSCO, SUNW and ORCL have never paid a dividend in their life, and probably don’t plan to in the near future.
A more realistic view of valuation is that you are paying for expected future earnings growth. Or expected future earnings, period, if you are talking about an internet company that has never made a dime. And, yes, it does have some aspects of a Ponzi scheme to my mind too. The logic holds only as earnings continue to grow.
Dividends are out of fashion now because of the tax consequences. If you give people dividends they are taxed as ordinary income. Companies now try to use this money to grow their buisness which drives the stock price up. If you hold on to the stock for more than a year and then sell it you are taxed at the lower capital gains rate. Capitol gains fed tax rate is 20% vs about 39% for high tax brackets.
Actual dividends create a minimum value for a stock, forming the “floor” that Cornflakes seeks in his/her OP.
Gazpacho’s comment is interesting in this light. It seems to argue that a capital gains tax lower than the dividend income tax makes divident payments undesirable. Thus it removes the floor, making zero the reasonable market minimum for a stock that does not pay dividends. It seems logical (although I am by no means certain or even confident) that such an action would increase risk and volatility for that stock.
Well, actually stocks don’t have to split. Berkshire Hathaway (BRKA) for instance is currently priced at
$1938/share! I’m not sure if this company has ever split since it’s inception.
BRKa is $59800/share at close today. Year high is $74K. Warren Buffet doesn’t believe in splits. I believe that company broke various reporting tools when the share price topped 5 digits.
Two reasons why splits are not just an accounting procedure:
1 - psychology. Naive buyers look at a $50 price and say “Gee, that’s a good price for ****” without knowing anything else, like what the company is actually earning per share.
2 - increased liquidity. If a company has a small float in comparison to its trading volume, it tends to be volatile. If there are more shares out there, small investors can buy finer grained chunks of the company in 100 share lots.