Wednesday, March 13, 2013

Investment Part 3: Stock Pricing

This is the final part of a three part series on understanding investment. The previous two postings can be found here and here. In this final posting I will attempt to explain the basics of how stock prices are established.

Stocks, like several other investments described in the previous sections, are a market investment. This means that fundamentally prices are dictated by supply and demand. When a stock becomes more desirable or more scarce the price will rise. When the converse occurs the stock will fall. Here is a brief example to illustrate this mechanism in action:

Tom is an apple seller along highway one. Every day he takes his apples from his apple orchard and stands next to the road selling apples to cars that pass use the highway. He sells apples for $5 each and makes quite a lot of money doing so.

On Monday Tom is startled to find that a dozen other apples sellers have set up along his road. They heard about his good fortune selling apples and now want a piece of the pie. All of them are imitating Tom's success and selling apples at $5. However, the demand for apples is unchanged and consumers pick which booth to stop at randomly (since each is the same) so Tom is making only 1/12th of what he made the previous week.  Tom, being an intelligent man, realizes that if he lowers his price to $4 he'll get all the business again. He'll only be making 4/5ths as much as he was previously but that's a lot more than 1/12th. So Tom lowers his price to $4 and drives the other apple sellers out of business. Here excess supply of apples has driven the price down to $4 instead of $5.

On Tuesday the local news reports that apples cause you to live forever. Tom's apple stand is flooded by consumers and he sells out of his day's supply before 9:00 am. He quickly runs back to fetch more apples but realizes he's got a golden opportunity. Everyone desperately wants apples. Whether he charges $5 or $10 he's still going to sell out and obviously $10 makes him a lot more money. So when he returns with his new batch of apples he doubles his price and makes a fortune. Here excess demand has caused the price of apples to increase.

The converse of both of the above examples is true as well. If nobody wants to buy apples (insufficient demand) Tom will lower his price in order to incentivize buyers. If Tom only has a few apples to sell (meaning it's easier to sell out) he'll raise the price and make fewer sales but get more money for each sale.

The key concept here is market equilibrium. Sellers have a range of prices at which they are willing to sell their stocks and buyers have a range of prices at which they are willing to buy.  When those values intersect an equilibrium is established and a stock price remains firm. When factors influence the demand for or supply of the stock the equilibrium shifts and a new price results.

Hopefully that has given at least a glimmer of how market investments work. Unfortunately, the above description is woefully inadequate. Markets are simply a summation of individual preferences. Thus to understand how stocks are priced you must also understand how individuals value stocks.

There are two primary methods by which individuals can value stocks. The first is a very mathematical, rigorous and sensible option. Unfortunately it also seems to be the more seldom used method.

Purchasing a stock is essentially buying a very small portion of a company, thus entitling the holder to a very small portion of profits. This distribution of profits to shareholders is generally known as a dividend. Most stocks do not pay dividends but for now we're going to pretend they all do. Suppose a firm earned $100 profit this year, has 100 outstanding shares and pays each share 1% of it's profits annually. It's easy to see that if nothing changes you'd earn $1 a year from each share of this stock. Essentially you would be purchasing an annuity of $1. It's easy to calculate the value of that dollar in perpetuity using the net present value method and thus arrive at a stock price that is sensible for an individual. However, the firm may also grow, retract, or even go completely bankrupt in the coming years. The likelihood and magnitude of these events must also be factored in to the individuals valuation. If the buyer thinks the firm is primed for massive growth in profits his annual return will growth quickly year after year so he'll be willing to pay more. As he projects further and further into the future however his expectations for the firm become more and more uncertain and thus he must rationally value expected gains further in the future to a lesser extent than more immediate gains. Still, even small expectation differences for the growth rate of a firm will result in large variations in valuation for a given stock.

As mentioned previously most stocks do not pay dividends and so this method may seem impractical. Most firms utilize what is known as retained earnings instead.  Essentially retained earnings are simply the dividends that would have been paid to the stock holders reinvested in the company.  This has a number of benefits. Firstly, earnings from stocks are taxed upon the sale of the stock while dividends are taxed constantly (since they are received frequently). Therefore when firms retain earnings rather than disbursing them stock holders can more easily regulate their tax liability. Assuming the retained earnings are not squandered foolishly (and if you believed that was the case why would you hold the stock in the first place) they will still increase the share price of the stock and thus not result in a loss of potential income to the stock holder. Secondly, if the money is utilized wisely by the company it will cause the companies stock price to increase even further. For example, suppose the $100 of dividends was instead used to buy a new factory which provided $130 of income after net present value calculations. This new income would be reflected in the stock price which would more than compensate stock holders for their foregone dividend payment.  Thus although dividend payers are a minority the NPV method of revenue stream calculation is still a sound approach to establishing individual stock valuations.

The second method of individual stock valuation is the "Greater Fool Theory".  This method of stock pricing seems to be the domain of pundits and editorialists both financially aligned and otherwise. Essentially the idea of the "Greater Fool Theory" is that if you buy "good" things someone will buy them from you later at a higher price. For example, if Applied Widgets has been doing well lately and is popular it's a good stock to buy. You can get it now and later when it's worth more you can gain some profit. This idea is a core concept of "momentum investing" and to be fair works quite often. Often times the market will become overly enthusiastic about a particular firm and many people make money by riding that wave of exuberance. However, attempting to time the market in such a fashion is essentially a guessing game. While it may work a significant portion of the time, when a buyer guesses wrong he'll often be stuck holding stock he over payed for and can't easily sell at a price he finds acceptable.

So, to briefly summarize, how are stocks priced? Individuals form personal valuations of stocks based on both rational and irrational methods. These individual valuations form a market which established a market equilibrium subject to market forces. This market equilibrium is the current price of a stock. There are a myriad of confounding factors that contribute to where that equilibrium is established but that is the essence of the system.

Next week I'll return to more academically interesting topics and leave this financial drudgery behind. Until then stay safe and rational.

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