(This is a continuation of introduction made in earlier lesson)
To start with, whichever way you look at it, fundamental value is defined by either the earning power of the underlying assets or in relation to the fundamental value of other stocks. This is because in any case, you are dealing with a business and a business’s purpose is to generate money for the owners in form of earnings. The market price ideally is supposed to tend towards its fundamental values.
The general misconception is that any differences between current stock prices and the fundamental values can be attributed to future developments in the companies concerned that are not yet known but are correctly anticipated by the stock market. Stock price movements are therefore assumed to precede the developments that eventually justify them. This has even been accepted by people who don’t put much faith in fundamental analysis but is almost always never the case.
Borrowing from George Soros’ explanation on the life cycle of a stock also known as the ‘boom and bust’ we shall assume that there is an underlying trend. The underlying trend in this case shall refer to the trend in fundamentals. I have picked the exact same illustration George Soros used in this particular case because I found it to be very simplistic compared to what other text books use. In the illustration that is provided below, we shall use earnings per share to represent the fundamentals. assumes that fundamentals are properly measured by earnings per share
Explanation on the path that stock prices normally follow
A-B: There is a lag in investors identifying the underlying trend in the earnings per share despite the fact that the trend is growing and at this stage the stock is still underpriced. Despite the failure of investors to recognize this in form of stock prices rising higher, the trend remains strong enough to manifest in earnings per share.
B-C: Underlying trend is finally recognized and is reinforced by rising expectations and as we can see from the graph, stock prices momentarily rise above the earnings per share. However, doubts arise and the process aborts, but trend in fundamentals survive. Alternatively, the trend waivers but reasserts itself. In real market situations, such testing may be repeated several times and may extend for a prolonged period of time especially if investors are suffering from a previous trauma experienced in investing in the same or similar stocks.
D-E: Conviction develops and it is no longer shaken by a setback in the earnings. Investor confidence is high and previous and current investors are rewarded by their shares trading at higher multiples.
E-F: Expectations now become excessive and fail to be sustained by reality which in this case would mean that the stock is highly over-valued. Investors are getting very little return on their investments for every share they buy. Eventually the bias is recognized as such and expectations are lowered especially when earnings start reflecting what investors were not anticipating.
F-G: Stock prices lose their last drop and plunge. Panic may further fuel the drop.
G: The underlying trend is reversed, reinforcing the decline
G-H: At this stage pessimism by participants is overdone and market stabilizes. By the time market is done with the downfall, bulls are usually disillusioned and that is where you get to see a lot of negative sentiment from the general public. The process repeats itself.
From this we can conclude that stocks can remain over-valued until investors recognize the underlying trend and change bias, as long as underlying trend continues to rise, eventually investors will recognize it and stock market price will rise to match fundamentals. Break in price ranges tend to cause rise in volatility and this is what can cause rise to be sometimes very sharp.
Can market price influence fundamentals?
Yes, I do believe in the theory of reflexivity because it is very practical. High market prices can positively influence the fundamentals of a company in different ways especially if instead of making acquisitions by cash, it makes acquisitions by offering its shares at much higher value. This would mean that the company can continue to increase it earnings to justify higher prices simply by acquiring other companies. To illustrate, assume business A and B are of the same size but business A has a higher market value than business B and is actually double, when it comes to acquisition, A can offer B its shares at a much higher multiple and hence increase its earnings by 50%. Investors on the other hand will see that the company is doing well by increasing earnings and therefore reward it with even higher market prices. This can be dangerous especially if acquisitions are of poor quality because it acts like a smoke mirror.
Low market prices can influence company’s credit rating (Affecting its ability to raise debt), consumer attitude, raising of money through rights and bonus issues (May have to really dilute shares and affect exercising of rights) etc.
If you did not understand the terminologies used, we will provide a tab with important definitions.