understanding individual stock valuation

When thinking about the value of a stock portfolio, it may be useful to think in terms of three different "fair" values which are all accurate, and of the stock price as jumping between them, like a train which can jump from one set of rails to another.


Let's consider the academic model of valuation to be the first value a stock can adhere to. The three key features of this model are 1) the output price it generates should be random from moment to moment, 2) it need not be tied to anything in reality, and 3) it is very popular and widespread. Meaning, the model can be totally wrong, and yet the train can hold to the random tracks, or the "artificial" price, for extended periods, broken up by only occasional cracks of reality.


Since the only rule governing what the academic model will be from moment to moment is that it will be silly and meaningless, the safest way to model it is like a set of dice. So let's say that there is a group of people who figure out how much a stock is worth by rolling a set of dice and multiplying it by 10. Only, there is such a majority of people who belive this, so many of them, and they all agree, that this can become a self-fulfilling prophecy and hold true for indefinite periods.


Also, it is important not to get confused by the model. Understnad that while we may knwo the numbers are teh output of a set of dice, the people followign them, for teh sake of this example, actually believe them to be a window into corporate profits or something.


The next rail of valuation, which a stock can begin to track along, is supply and demand. It is all very well that both buyers and sellers alike think that a stock is worth 50 - and that the Moon is made of green cheese - but if there are more buyers than sellers, it is hard for the stock not to begin to rise to 52 and 53. Slowly, the stock migrates into the hands of the subset of people who think that the way to divine coprorate prospects is to roll a set of dice and multiply by 11.


So how long can stocks trade at prices simply because people believe they are worth a certain amount, and regardless of "intrinsic" value? To get an idea, it helps to consider the value of something with no intrinsic value whatsoever, a paper dollar bill. Obviously, a dollar bill only has value becasue people know other people will assume other people will think it does. And if everyone else is standing up in the bleachers, it does no individual any good to sit down. But the point is that, when we roll the dice for values to plug in, it doesn't matter what we think we are modeling, so long as we all agree!


Obviously, the only way the price of the dollar can be propped up and stabilized is through very strict control of supply. The Fed raises and lowers the fed funds target rate, and they lock up counterfeiters and throwing away the key. They prop up the faith by ensurign that the money supply accurately reflects the number of goods in the economy, so that peopel don't invest or consume more good then their really are, and end up with a bunch of leftover money and nothing to claim with it. The Fed pulls money out, before supply can push the value of money down - inflation - whcih will slowly alter the popular perception of its value.


In the dollar, perceptions follow supply and demand, which is fixed by the government. In stocks perceptions are created by past supply and demand trends, and supply and demand are also moving independently beneath the surface.


Notice, again, that the value of a dollar is completely free floating, tied to nothing. The goal of the Fed is simply to make a dolalr worth what it was yesterday, and to try to make it have the same value tomorrow. They wouldn't care if it cost $10,000.00 for a stick of gum, only that whatever this figure it not change from year to year. The academic/dice model of stock values, on the other hand, when deciding what the price of a stock "should" be, is bound by almost nothing.


Notice the differences, however. The Fed can actually control the supply of money, to match the demand for it created by the production of goods. Both the supply of and demand for stock, however, arise from business conditions. So whereas, with the dollar, the Fed tries to regulate supply to where the bubble of popular perceptions is never punctured, in the stock market, the bubble of perceptions is constantly being gnawed at and eaten away. Periodically, but only periodically, the stock bubble breaks.


The mechanism by which stock prices are adjusted, slowly and occasionally, to meet reality, is arbitrage. When the dice model spits out a price for stocks that is too low, people can buy companies in the stock market - by buying stock at a price beneath one that is tied to anything - and operate the companies, or break them and sell them, for a profit in the real world.


When interest rates collapsed and liquidity increased in the 1980's - as the availability of all products from gasoline to computers skyrocketed - there was not the huge institution for funneling the public savings into the stock market that there is today. So as credit expanded - the ability to "invest" immediate excess goods for a future profit - the dice-model price for stocks did not rise accordingly, as it would if there were any "sense" behind it. So what you had was an outsized volume of levergaed buyouts, where people bought in the stock market, and sold in the credit market, performing arbitrage between the nonsense price and the real world.


Then, in the late 1990's, when the dice started producing a price that was too high, the corporate raider was replaced by the venture capitalist, who manufactured companies to sell into the stock market. But notice, still, how long it took for perceptions to crack, even after supply had caught up with demand!


Also, don't picture the two sets of rails - on the one hand the actual supply of and demand for investments and, on the other hand, the perceived value of investments - as running totally independent courses. The perception does not oscillate around the fundamental without wagging it a bit, like the tail wagging the dog. If, for instance, the perceived value of stock is lower then the actual value, corporate profits could rise even faster, as not as much money will be invested, and nots as many new competing corporatison will be formed, as their theoretically should be.


But I lost the vision I was trying to communicate, which brings us to the topic at hand, the valuation of individual stock. It is hard for individual stocks to be undervalued, because somebody can always take them private. but it is easy for indivudal stocks to be overvaloued, and to stay that way indefeintley, because whielit is easy to manufactrue stock in general, it is very hard to manufacture individual stocks. Meaning, if the dice produce a price X for bowling ball manufacturer Y, it is hard for somebody to supply an extra bowling ball maufacturer Y, it just won't be the same thing. People will say, well that is bowling-ball manufacturer Z, and we still like Y.


Anyway, now I've completely lost my train of thought. But I know it had something to do with predicting the price of stock when nobody has any idea what is going on, and no arbitrage can take place even if somebody does. The supply cannot rise to meet the demand, the only way the price can drop is if people change their minds.


And that is what you saw happen when people, at about the same time, realized what AOL was going to be doing 10 years out, and saw Yahoo considering buying EBay and realized it was all just banner adds, Yahoo wasn't going to change the way people lived or society functioned somehow. There were catalysts in the Spring of 2000, only the catalysts could not have been anticpated. Only when the chart first started to dip, and you saw the cracks form, long before the big days hit, you could have seen as I did that there was something shifting underneath the market.


I predicted a BIG washout only a few days off the high AND NOT A DAY SOONER! This interests me, because I also called the September 2001 low to the day, but this puzzled me, because it seemed like everyone else did as well. I asked someone, how is it that not just me, but everyone else also picked this low correctly, isn't that impossible for everyone to be right? My friend explained to me that "everyone" had been calling the low every month for a year and a half!


Anyway, I guess the point of the essay was 1) that nobody has his hands on the wheel or knows what is going on at an individual company, 2) the price people choose to pay is totally random, and 3) there is no arbitrage to prevent the price from rising above fair value.


So it's awfully easy to find good shorts, and awfully hard to time them. You have to predict your catalysts, whether they be earnings reports or who knows, months if not years in advance, and then jump hard when the Fed starts tightening, or when enough competing stocks have been manufactured to lure away some suckers.


And there may be some good longs out there in the land of individual stocks, some undiscovered companies. But they're even harder to find, and may require every bit as much patience. I haven't had that much luck picking fundamental longs. Though it's no trouble at all predicting bull-market high-flyers! So I guess just buy the nifty 50 when the market rises, and short the obscure local dogs when it tanks. If you stock-pick "undervalued" stocks on the long side, all you're achieving is picking the stocks which, for some reason, are immune to ridiculous perceptions.


Or something...


I wish I could remember the point!


leroy

i said no message. thats what n/t or n/m means why are you so noisy.

I believe that your point is that in the short run, while you may know WHERE prices are going, you can't really profit unless you know WHEN prices are going.


My alternative suggestion is that over the long haul and over the entire market, equity prices move up/down according to increases/decreases in GDP, inflation and investor sentiment. There's no telling when these changes will occur. Don't market-time. Use cheap index funds. Stay invested. Good luck and see ya at the finish line in 35 years or so. Russ.