Back To Basics, article by Joe Clark, CFP

The excitement begins when the NYSE bell rings at 9:30 EST. Wall Street begins trading stocks or equity, representing ownership in thousands of companies.  Willing buyers and sellers meet at an agreed-upon price and ownership transfers.  By 4:00 EST, over two billion shares on average will trade hands.

The interesting part is the price exchanged per share.  Where does the valuation come from, and what is the most accurate reflection of what a company is worth?  The price for one share of a company stock daily is determined by what someone else is willing to pay.  Period.

What about different investment strategies, money managers’ styles, and studying the financials, and what about the fundamentals? Don’t any of these considerations count?  Sure they do, but it is all perspective.  The fundamentals apply to the share price only to the extent they influence a particular buyer or seller of the stock.

Economists tend to discuss the fair value of the entire company’s value-based estimated earnings and the current economic cycle.  Investors use that value and divide it by the number of shares outstanding to determine what a fair price for the stock should be.  Today, the analysts will do the math for you and provide their thoughts per share.

The exciting part is that the best in the business don’t agree on fair value.  You’re thinking (or You may be thinking), “Come on, Joe, you are dealing with semantics and a few pennies per share. What’s the big deal?” The big deal is that sometimes fair value is in the beholder’s eye, even when it comes to the big boys.

An experiment reported on November 19, 2007, had Standard and Poor’s and Morningstar face off for determining fair value. Both firms assigned their reasonable price-point for the 30 stocks in the Dow Jones Industrial Average.  Morningstar provided a significantly higher value to three companies, while S&P assigned a significantly higher value to 3 others.  The two firms disagreed on 12 of the 30 stocks in deciding whether the current stock price was higher or lower than fair value.  Only 8 of the 30 stocks found a price where the fair value was determined to be within 10% of what the two firms agreed upon independently.

The same arguments are being made for companies like Tesla today. This morning, two analysts had price targets for the stock substantially different than the current price. Both are paid to study the company and could not be further from agreement. Tesla is now the fifth-largest company by market capitalization. These are significant issues.

You can study the company’s fundamentals business model, management team, demographics, and the rest of the financial data, concluding at what price you are willing to invest or sell. Keep in mind, the person on the other side of the trade has access to the same information! The share price paid is often determined by the emotional aspects of an overall market, with the final justification for the action being rationalized with logic afterward.

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