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No stock's price is set by its popularity; it is a function of its perceived value | |||
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By DAVID MOON, Moon Capital
Management Every time shares of a stock are traded, there is a buyer and seller. The price at which they conduct the transaction is the stock market's current best estimate of the value of those shares. But as we now painfully know, the market is often wrong. In fact, given the incredible volatility of stock prices and the constant intra-day fluctuations, the market is usually wrong. During a three-hour flight from New York to Los Angeles, an airplane is off its precise course about 98 percent of the time. The pilot is making constant adjustments to keep the plane headed in the direction of Los Angeles. Almost all of those adjustments are so minor as to be unnoticed by the passengers. A stock price is the same. Every time a stock price moves a few pennies per share, the market is adjusting its estimate of the value of the stock, trying to keep the price moving in the correct direction: toward its value. Unlike when a plane reaches its destination, however, a stock is just as likely to continue past its value and go off course in another direction. There is no ending point for the stock market. (That is, unless a company is purchased or goes bankrupt. In these cases, the stock price will continue to move toward it value - zero in the case of a bankruptcy; the takeover price in the case of an acquisition - until it arrives at its final destination. In most cases however, a stock price's journey is never ending.) And while the value of a company doesn't change rapidly, it will change. So as a stock price moves towards its value, the price uncertainty and volatility is made more dramatic by a moving target: changes in the value of the underlying business. The price of a stock is an easily observable fact. But what is the value of a stock? The value of a company is simply the total amount of cash a business will generate for its owners over the life of the business, expressed in today's dollars. The variables are easy to identify: 1) the future cash flows If an investor knows each of these three variables with absolute certainty, he can easily calculate the precise value of that business. That value would not be constant, however, even if the anticipated future cash flows remained constant. The value of that business would still be susceptible to changes in the time value of money factor, which is a function of interest rates and inflation. As interest rates change, the value of any fixed income stream also changes. A business that never generates any cash for its owners is worthless. Simple. Worshipers at the dot.com altar missed the lesson. The dot.comaniacs focused on their stocks ' which were really just pieces of paper ' rather than the businesses represented by those pieces of paper. They falsely believed that a company's value depended on whether or not someone wanted to buy the stock. If they could anticipate which stocks would be popular next week (or month or year), they believed the long-term profitability of a company was irrelevant to its value. Stock values are not determined by supply and demand. Ben Graham was right: in the short run the market is a voting machine, measuring the collective votes cast by buyers and sellers. But in the long run, the market is a weighing machine, ultimately measuring the value of the businesses represented by stock transactions. David Moon is president of Moon Capital Management, a Knoxville-based investment management firm. This article originally appeared in the News Sentinel (Knoxville, TN).
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