How Stock Prices Are Determined

Why Stocks Become Overvalued and Undervalued - Investing Lesson 2

Why Stock Prices Become Overvalued and Undervalued
Stock prices fluctuate for a number of reasons, which can lead to overvaluation or undervaluation. Steve Chenn / Getty Images

As you may have learned by reading Introduction to Wall Street, the purpose of the capital markets is three-fold.  At the risk of repeating myself, I'm going to quote the relevant passage verbatim and encourage you to read them again before I get into the details:

  1. To establish the primary market by connecting savers of capital with those who want to raise capital, most commonly either by borrowing it through the issuance of bonds or by selling ownership in a business through the issuance of stock.  This is the core reason Wall Street is so important because it is what makes capitalism work; what moves money efficiently to its most productive uses, increasing standards of living over time.
  1. To facilitate a secondary market for existing owners of stocks and bonds to find others who are willing to buy their securities so they can raise cash, which has the effect of making primary markets more successful as investors have more confidence in the ability to use their portfolio as a source of liquidity, generally demanding lower risk premiums as a result.
  2. To assist those who wish to outsource the job of investing their capital so the client can focus on his or her primary career or activity.  Sometimes this is done through a broker-dealer.  Increasingly, this is done through a firm that is a registered investment advisor which is bound by a fiduciary duty to put the interests of clients above the interests of the firm, including registered investment advisors that are primarily asset management companies.  That way, if you are a high earning, successful individual such as a software developer or a doctor, you can pay someone else to handle your portfolio as you focus on generating more money, not reading 10-K filings or mutual fund prospectuses.  As a Managing Director of Kennon-Green & Co., the asset management group through which I will manage my family's capital and the money of wealthy and affluent private clients who want to invest alongside us once it opens its doors later this year, this is where I will be spending what I expect to be the remainder of my career.  

    The stock price fluctuations - stocks becoming overvalued or stocks becoming undervalued - arise on the secondary market.  That is, once a company has raised capital from investors, it is those investors, or owners, buying and selling among themselves based upon a number of relevant factors that determines the current market value of a trade.

     The potential buyers announce a price at which they would be willing to pay, known as the Bid.  The potential sellers announce a price at which they would be willing to sell, known as the Ask.  A market maker in the middle works to create liquidity in the market by helping facilitate trades between the two parties.  When a buyer and seller comes together, a trade is executed at the price at which the trade occurred becomes the quoted market value you see splashed across television ticker tapes, Internet financial portals, and brokerage account pages.

    Although there is a school of thought known as efficient market theory, which stakes the current market value of a stock is the true value, reflective of all known information, it's total bunk; absolute nonsense taught by academic theologians arguing about angels dancing on the head of a pin.  The theory has been softened over the years due to the complete mental derangement it represents that it is now little more than common sense.  In actuality, companies trade for more or less than they are really worth all the time.  That real value - something Benjamin Graham called "intrinsic value" - is the net present value of the owner earnings; the cash that can be extracted from the enterprise from now until the end of time if you could never sell it and had to hold forever based on the actual productive capacity of the business itself.

     Included in that calculation is the so-called risk-free rate.  In the United States, that is the rate on long-term U.S. Treasury bonds.  (One interesting exercise to compare equity prices is to look at the earnings yield on stocks and compare it to the Treasury yield.)

    What kind of situations could cause a company to sell for more or less than its intrinsic value?  While there are many, four particularly interesting ones you should know about as a new investor are:

    1. The fight between investors and speculators driving the price in any given direction
    2. The commodity nature of stocks
    3. Life (it sounds general, but it will make more sense later)
    4. Temporary problems in a business that can cause people to lose faith in its long-term earnings capacity

    We're going to walk through each of them individually.

    First, let's look at investors and speculators.

    This page is part of Investing Lesson 2 - What Makes Stocks Become Over or Under Valued.