Reminder on Stock Valuations and Pricing

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eurowizard
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Reminder on Stock Valuations and Pricing

Post by eurowizard » Mon Jan 04, 2010 11:11 am

A very common misconception I see in numerous places is that the stock price is somehow determined by supply and demand. As if when investors panic and sell stock it somehow drives the price down, or if investors get greedy and decide to buy more stock, it somehow drives the price up.

This simply is not true. The stock prices are determined by what the market as a whole think the company's future earnings are worth. Changes in stock prices are based on changes on this projection.

If Apple announces a new Tablet PC and that increases expected future earnings, then the stock price goes up. If Steve Jobs dies, and that decreases projected future earnings, then stock price goes down.

Here is why this is true. Imagine a stock called BOGLE that is trading for $100.00 per share. Jim Kramer starts talking about BOGLE stock on his TV show so people start buying it in huge volume. The price temporarily ticks up based on supply and demand because all the BUY orders are matching all the SELL orders in place at $100.01. So then the new BUY orders will match SELL orders at $100.02.

However, once the market price has been breached, people holding the stock will look at the price at $100.03 and say, "It's not worth that much. It's only worth $100.00. I can sell it at a 3 cent free profit." and thus start driving the price back to the market equilibrium of $100.00

Now imagine BOGLE only has 100 outstanding shares out there owned 1 share each by 100 people. Future earnings shift such that now it's worth $200 by forecasting. It doesn't require that any of those 100 people sell their stock for it to be worth $200. It's already worth $200.

The point of this post is don't fall into the hype of panic selling or irrational buying. Stay the course.

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ddb
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Re: Reminder on Stock Valuations and Pricing

Post by ddb » Mon Jan 04, 2010 11:27 am

eurowizard wrote:A very common misconception I see in numerous places is that the stock price is somehow determined by supply and demand. As if when investors panic and sell stock it somehow drives the price down, or if investors get greedy and decide to buy more stock, it somehow drives the price up.

This simply is not true. The stock prices are determined by what the market as a whole think the company's future earnings are worth. Changes in stock prices are based on changes on this projection.
I don't see the difference. If projected earnings increase, demand goes up while supply stays the same, so the price goes up. It's still a simple supply-demand relationship.

- DDB
"We have to encourage a return to traditional moral values. Most importantly, we have to promote general social concern, and less materialism in young people." - PB

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eurowizard
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Re: Reminder on Stock Valuations and Pricing

Post by eurowizard » Mon Jan 04, 2010 11:44 am

ddb wrote: I don't see the difference. If projected earnings increase, demand goes up while supply stays the same, so the price goes up. It's still a simple supply-demand relationship.

- DDB
Good Morning,

The difference is that in your example the "demand" is driven by an increase in value. This is equivalent to a local bank saying, "Anyone who brings in fifteen $1 bills today will receive a $20 bill in exchange. There is no "increased demand" in $20 bills. It's just that the bank is selling them at a discount. If a stock is $100 today and tomorow earnings forcasts change and it's considered to be worth $200, then people will continue to buy it until it reaches $200 and hits equilibrium. It's a shift in the demand curve, but not what I am referring to.

What I am describing is if the average joe starts seeing the market recover, and decides to jump back into the stock market, it will NOT affect the stock market prices. All this "cash on the sidelines" nonsense spewing on CNBC is not a factor in stock valuation and pricing.

Similarly, the stock market didnt "crash" in 2008 because people paniced and snowballed stocks further downward. The prices of stocks would have been exactly the same if everyone had held their positions.

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ddb
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Re: Reminder on Stock Valuations and Pricing

Post by ddb » Mon Jan 04, 2010 11:59 am

eurowizard wrote:The difference is that in your example the "demand" is driven by an increase in value. This is equivalent to a local bank saying, "Anyone who brings in fifteen $1 bills today will receive a $20 bill in exchange. There is no "increased demand" in $20 bills. It's just that the bank is selling them at a discount. If a stock is $100 today and tomorow earnings forcasts change and it's considered to be worth $200, then people will continue to buy it until it reaches $200 and hits equilibrium. It's a shift in the demand curve, but not what I am referring to.
Okay, I think maybe we're arguing semantic. Stock prices move as a result of supply and demand, which I think is inarguable. You seem to be citing the factor that most influences demand, i.e. the present value of projected future earnings. Still, let's not pretend that this is the only factor which leads to changes in demand. A lot of trading out there is done for reasons other than a perceived change in the present value of future earnings.
What I am describing is if the average joe starts seeing the market recover, and decides to jump back into the stock market, it will NOT affect the stock market prices. All this "cash on the sidelines" nonsense spewing on CNBC is not a factor in stock valuation and pricing.
Agree that the "cash on the sidelines" issue doesn't mean much.
Similarly, the stock market didnt "crash" in 2008 because people paniced and snowballed stocks further downward. The prices of stocks would have been exactly the same if everyone had held their positions.
Not really. If there are no trades, then there is no price change (there's a VALUE change, but your brokerage firm is reporting your year-end values based on last trade, and not on a custodian-determined valuation of the underlying company!).

- DDB
"We have to encourage a return to traditional moral values. Most importantly, we have to promote general social concern, and less materialism in young people." - PB

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Post by richard » Mon Jan 04, 2010 12:05 pm

Stocks, as well as all other goods and services, trade at the intersection of supply and demand curves. We can argue over the effects of various events (including perceptions of value) on supply and demand and therefore on pricing, but that doesn't change basic economics.

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bob90245
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Re: Reminder on Stock Valuations and Pricing

Post by bob90245 » Mon Jan 04, 2010 12:12 pm

ddb wrote:
Similarly, the stock market didnt "crash" in 2008 because people paniced and snowballed stocks further downward. The prices of stocks would have been exactly the same if everyone had held their positions.
Not really. If there are no trades, then there is no price change (there's a VALUE change, but your brokerage firm is reporting your year-end values based on last trade, and not on a custodian-determined valuation of the underlying company!).
What about this example. A person buys a home in 2007 for $500K. He still owns the home (it hasn't been traded). But now because of the housing crash, he would no longer be able to sell it for $500K. Is it still worth $500K because he bought and held? Or is it worth $400K because that is what the same house across the street has just sold for?
Ignore the market noise. Keep to your rebalancing schedule whether that is semi-annual, annual or trigger bands.

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ddb
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Re: Reminder on Stock Valuations and Pricing

Post by ddb » Mon Jan 04, 2010 12:18 pm

bob90245 wrote:
ddb wrote:
Similarly, the stock market didnt "crash" in 2008 because people paniced and snowballed stocks further downward. The prices of stocks would have been exactly the same if everyone had held their positions.
Not really. If there are no trades, then there is no price change (there's a VALUE change, but your brokerage firm is reporting your year-end values based on last trade, and not on a custodian-determined valuation of the underlying company!).
What about this example. A person buys a home in 2007 for $500K. He still owns the home (it hasn't been traded). But now because of the housing crash, he would no longer be able to sell it for $500K. Is it still worth $500K because he bought and held? Or is it worth $400K because that is what the same house across the street has just sold for?
I'm not debating the value issue, but the reported price issue. Stocks are priced continuously based on last price - that's just how it works. If there were no trades of a stock in a year, the year-end value of the stock on your brokerage statement would be the same as it was the year before.

- DDB
"We have to encourage a return to traditional moral values. Most importantly, we have to promote general social concern, and less materialism in young people." - PB

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eurowizard
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Re: Reminder on Stock Valuations and Pricing

Post by eurowizard » Mon Jan 04, 2010 12:21 pm

bob90245 wrote: What about this example. A person buys a home in 2007 for $500K. He still owns the home (it hasn't been traded). But now because of the housing crash, he would no longer be able to sell it for $500K. Is it still worth $500K because he bought and held? Or is it worth $400K because that is what the same house across the street has just sold for?
It's worth $400k.

Lucio
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Re: Reminder on Stock Valuations and Pricing

Post by Lucio » Mon Jan 04, 2010 12:35 pm

ddb wrote: I'm not debating the value issue, but the reported price issue. Stocks are priced continuously based on last price - that's just how it works. If there were no trades of a stock in a year, the year-end value of the stock on your brokerage statement would be the same as it was the year before.
I wonder if that's what the investors in Pakistan experienced last year? The Karachi exchange did not close, exactly, but for four months or so, no stock was allowed to trade at a price below the price at the beginning of the crisis.

http://en.wikipedia.org/wiki/Karachi_Stock_Exchange
http://www.bloomberg.com/apps/news?pid= ... ld_indices

Lucio

lostcowboy
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Re: Reminder on Stock Valuations and Pricing

Post by lostcowboy » Fri Jan 08, 2010 11:48 pm

eurowizard wrote:A very common misconception I see in numerous places is that the stock price is somehow determined by supply and demand. As if when investors panic and sell stock it somehow drives the price down, or if investors get greedy and decide to buy more stock, it somehow drives the price up.

This simply is not true. The stock prices are determined by what the market as a whole think the company's future earnings are worth. Changes in stock prices are based on changes on this projection.

The point of this post is don't fall into the hype of panic selling or irrational buying. Stay the course.
I think you are taking a to simple view of the stock market. You should look in to the funtion of the specialist and the market makers.
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