What information does the stock price really tells about a particular stock? How do you decide if a stock is a buy for you? How much information do you need to tell?
There is actually a huge difference between the stock price and the stock value and both are equally important for the investment evaluation.
While the stock price is the current price at which a company is traded on the stock market, the stock value actually depends on the underlying business and for several reasons that we are going to see, they aren’t always the same.
By resolving the difference between price and value you come to a curious fact: the stock market is the only place that when stuff is on sale people run away.
Stock Price (or Market Price)
Getting the stock price is very easy and all you really need to do is a simple Google search about the stock. However, what exactly does this quote mean?
Briefly and simply stated:
A stock’s current price is whatever someone is willing to pay for it.
Indeed, the price of a stock depends on market forces, namely the dynamics between a large number of potential buyers and potential sellers that place their orders on the stock market.
That’s it. If there are more buyers than sellers it means that the stock’s price will rise, on the other hand, if there are more sellers than buyers the price price will fall. Not necessarily the value.The stock price is the highest amount someone is willing to pay for the stock, or the lowest amount that it can be bought for. This number changes every second and the price of the next transaction on the market might be higher or lower, depending on supply and demand.
Drivers of Stock Price
So the question becomes: why are there more buyers or sellers for a given stock?
It is the result of the behavior of the plethora of different subjects that operate on the market, everyone with a different view, a different goal and different expectations.
Just think about the style of the trader that is looking for immediate gains on short term fluctuations in comparison to the pension fund manager that wants to build a retirement fund for its clients. There are hundreds of ways to operate in the stock market.
The large number of factors that influence the expectations of market participants includes:
- Overall market trends
- Analysts estimates
- News, good or bad
- Monetary Policy
- Confidence or lack of it in the economy
- Company news, such as earnings, financial issues or scandals
Often times, the stock price is in line with the consensus of the analysts’ estimated value but every piece of news or change in the economy can result in huge price movements over short periods of time.
Current Market Value
Market value, also known as open market valuation or market capitalization, is just the valuation of a company calculated from the current stock price.
In other words, it is what the market thinks a particular company is worth today.
It can be a good indicator of investors’ perceptions about a company, however, that value changes everyday (even if the business itself might have not changed at all) because each trading day market operators have slightly different perspectives.
Current market value reflects supply and demand from sellers and buyers, and it might be higher than the intrinsic value of the company if there is a strong demand or lower if there are more sellers than buyers.
According to this statement, there are many situations where stocks can be overvalued, fairly valued or undervalued.
This brings us to the most important question that every mid-term or long-term investor should answer before taking any investment decision:
What is the value of the company?
Stock Value (or Intrinsic Value)
We saw that getting the price is very easy, it depends on the stock market and it doesn’t really say anything about the quality of the business.
Figure out the real value of the stock is far more complicated and I must state clearly that there is not a single evaluation method nor a 100% accurate system to find it.
The starting point to determine the value of a stock is to remember what a stock really is: it is a piece of a real business.
Therefore, if you want to seriously evaluate a stock, it is necessary to understand and evaluate the business that the stock represents.
The stock value depends on the value of the company
This is why equity analysts dig deeper in the company financials, operate financial modeling and estimate future growth for the business and the whole economic sector in which it operates.
What Is The Value of a Stock?
From the shareholder point of view, the stock value is proportional to the company’s ability to produce cash flows in the future.
To understand the business and figure out an estimate for this value, the investor has to perform an extended analysis that takes into account variables like business profitability, financial strength, competitive advantage, capital structure, management, products, customers, technology and sector dynamics (the list could go on).
This leads to an interesting truth: while the stock price is given by the market, the stock value is always a personal estimate.
The number of things to consider is very large, there is a lot of conflicting information, a ton of hidden factors and several investing philosophies. This results in the lack of a general agreement upon the value of the stock.
How to Figure Out the Stock Value
Stock market investors typically pay attention to several figures and indicators based on published facts and numbers.
Here are some of the most common factors to watch out for company evaluation:
- Free cash flow
- Growth perspectives
- Market share
- Equity growth over time
- Revenues volume over time
- Potential and current competitors
- Price-to-earnings ratio
- Price-to-book ratio
While it is important to check and understand past and present figures, it’s even more important to carefully formulate future projections.
To better understand the company and the competitive environment, it is possible to access lots of information by reading the annual reports and reports by analysts that follow the company.
While the information is public and accessible, there are many interpretation of the same numbers.
Stock Price vs. Stock Value
The foundation of a large part of today’s financial theory is the Efficient Market Hypothesis (EMH). This theory states that the price of every asset in the financial markets reflects all the information available, therefore it trades at its fair value.
According this theory is not possible to find stocks that are overvalued or undervalued because, if the market is efficient, price equals the value.
If this were true, nobody would be able to make excess returns or beat the market. The reality, however, shows a completely different picture.
There are many great investors that repeatedly and consistently beat the market and have been doing that for decades.
Why Is There a Difference Between Stock Price and Stock Value?
It’s easy to believe that the stock value depends on the stock price, but there is a huge difference between the two, especially in the short term.
The most important distinction between price and value is the fact that price is arbitrary and value is fundamental.
- The stock price depends on Mr. Market, it changes every day and doesn’t necessarily reflects the value of the company.
- The stock intrinsic value, which is the company actual value, is determined by a deep analysis of the company’s business, which includes a fundamental analysis and the forecast of future projection.
Finding an accurate figure for the stock value isn’t an exact science and it is also a very hard process. Given that it’s quite difficult and highly subjective, there’s almost never a consensus about what kind of stocks should be bought and sold at a given time.
This implies that the market is often inefficient, in these circumstances stock value and stock price are not the same.
Why Stocks Get Mispriced?
The key to answer this question is to ask ourselves whether the stock market is efficient.
The Efficient Market Hypothesis makes sense, financial markets should reflect all the information available, stock prices should be related to fundamentals and companies growth perspectives.
That is true if you consider a long period of time, but in the short term anything can happen.
As Warren Buffett said in the 1993 letter to shareholders, expressing this concept in a very clear way:
“In the short-run, the market is a voting machine – reflecting a voter-registration test that requires only money, not intelligence or emotional stability – but in the long-run, the market is a weighing machine.”
The reason why stocks get mispriced is because markets act emotionally.
Markets are rarely efficient, in some situations participants are willing to pay any price when euphoric and sell at any price, even extremely low, when they are in panic.
Here is where the big opportunity lies, that’s when rational investors want to buy.
The emotional component plays a crucial role in setting the short-term price: fear and greed lead to an irrational behavior that makes the price shifting away from the underlying intrinsic value of the business.
Price Is What You Pay, Value Is What You Get
Finding differences between price and value is by far the most effective investment strategy. It is not a surprise that a large portion of the greatest investors of all time are value investors.
Value investing is considered to be one of the most successful strategies for long-term investing and it is based on spotting the difference between price and value and act rationally upon that.
Neither of them is easy, fast and straightforward, but the long-term reward is super high and if you think for a moment this strategy makes a lot of sense.
When you enter a shop to buy a physical product that you want there is a price on the price tag that you have to pay in order to get the product. If there are sales and you can get the exact same product for half the price, you are happy.
The same is true on the stock market: the price tag is the current stock price offered by the market and during downturns it happens that you can get the same stock (that you want) for half the price. The only difference is that when there are sales most of the people run away!
This is the result of acting emotionally instead of rationally. In addition, you should consider that a large part of the stock market is in the hands of institutional asset managers that want to save their performance not to lose their clients.
These fund managers need to get out of the market before it crashes, and before their peers. The fact is that in doing so, they are the cause of the crash itself.
Remember: the stock price depends on buyers and sellers. While in the long-term fundamental factors are the driver of stock price (economy, earnings and company growth), in the short term the price is ruled by supply and demand.
That’s why Buffett said that in the short-run the market is a voting machine while in the long-run is a weighing machine. We could say that markets are generally efficient in the long run but highly irrational in the short term.
A Quick Word on Value Investing
The incredible success of many value investing strategies should serve as the proof that differences between stock price and stock value happen quite often.
Value investors really see stocks as part of a business and the entire investing process starts from company analysis.
Value investors look for undervalued companies, making their investing decisions based on research, facts and a careful assessment of their valuation for the company, without the influence of what the stock market or financial analysts have to say (which remains their view, subject to their biases and their (usually short-term) focus).
In short, the key to be a successful value investor is to be willing and able to perform a deep company analysis and act without emotional biases or following the crowd.
They don’t base their decisions on historic price movements (this is traders’ job), they get down to work to figure out the value of the company.
Once they come up with their value, the price on the stock market is the last thing to be checked. Then, they invest only when they can buy the stock at a price that is lower than its value.
Why isn’t everyone a value investor?
There are many possible answers, but I would say that there are two main factors:
- It is not easy and straightforward, it requires a lot of analysis and a lot of patience
- You need to be a contrarian, doing basically the opposite of what everybody else (the market) is doing. While it is not easy by a psychological point of view, realize that some players in the market simply can’t unless they want to lose all the clients (e.g. large fund managers)
In the end, you really have to know what you are doing to perform this investing style.
However, is offers the basis for great long term returns achieved through buying undervalued stocks with a margin of safety thanks to the lower price that you pay.
In the long-run, the market is a weighing machine and sooner or later will recognize the value of the company, adjusting the price accordingly.
If you made it to the end of the article: congratulations!
We covered a lot of stuff about stock prices, stock values, their drivers, market efficiency and potential mispricing. By now, I hope that you understood the difference between price and value and recognize that oftentimes mispricing happen.
Here is a summary of the takeaways from this article:
- Everyday the stock market (or Mr. Market) offers a price that is different from the previous days
- In the short-term, the stock price depends mostly on supply-demand equilibrium between buyers and sellers while in the long-term it tends to reflect company fundamentals
- There is a large number of participants on the financial market, each one of them has different goals, behaviors and points of view
- Remember that a stock is one share of a real business, therefore its value depends on the value of the underlying company
- Calculating the stock value is tricky, there is a ton of factors to be consider and the evaluation is always subjective. There is not a general consensus about the company value
- Sometimes, when markets are emotional, ruled by fear or greed, stocks gets mispriced. In these situations, the rational investor can take advantage of the opportunity to buy or sell because he know the value of the stock
- Value investing is about finding undervalued companies, buying them at a price below the intrinsic value waiting for the markets to recognize the real value of the company. It requires a deep analysis of the company and implies going against the crowd
- Despite the Efficient Market Hypothesis, there is a number of successful investors that repeatedly and consistently beat the market and have been doing that for decades
Investing goals are personal and depend on your interests and your outlook. You might be more interested in short-term gains, attempting to predict sudden changes in stock prices, or maybe you are more long-term oriented.
In both cases, being aware of these dynamics of financial markets can help in making the right decisions with your own investing portfolio.
Keeping a long-term view doesn’t mean to buy and forget because the market changes. It is important to reassess our valuation for companies on a regular basis in order to rebalance the portfolio.
In the end, learning to value a company, make your own analysis and don’t care what the market is doing can really help you gain an edge in the stock market.
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This article is for informational purposes only, it should not be considered financial advice. You can read the full disclaimer here.