While the GameStop controversy has faded from the news headlines, the issue is still roiling the markets. I was listening to an analyst who was saying that the people who are driving up the price of the stock may themselves end up losing a bundle. Some analysts are calling it yet another bubble that will burst at some point and then the stock price will revert to a more realistic value. But what is a realistic price of that stock? It seems to me that the price of a company’s stock is not based on anything tangible.
The price of a tangible object like a car, for example, would be roughly based on the cost of the raw materials plus the cost of the labor that went into its production plus the overhead costs plus the profit, with the sum total divided by the number of cars that are produced. If we think analogously, the price of a company’s stock would be based on the value of the sum of the company’s assets divided by the amount of stock that the company sold. In the old days when companies were mainly brick and mortar and had physical assets, one could place at least an approximate value on all those things and arrive at a rough value for the price of the stock.
In other words, one starts with the value of the company using some more-or-less concrete measures and then calculate the price of the stock. But nowadays it seems to go the other way. It is the price of the stock that determines the value of the company. Stock prices seem to be more like the price of a painting which may have very little relationship to the cost of the materials and the labor of the artist. It is determined by what people are willing to pay for it based on all manner of intangibles, such as whether they think that the company (or the work of art) will rise or fall in value in the future. Even a tweet from Elon Musk about some stock can cause it to rise dramatically.
The professionals in this business act as if they know how to price a company’s stock based on things like the price-earnings ratio. They confidently state that a stock is undervalued and should be bought or overvalued and should be sold. But I don’t really understand how they arrive at those judgments and it is this that stops me from having any ambitions of becoming a collector of any kind or directly investing in the stock market. I have no stomach for that kind of guesswork where you decide what to do based on what you think other people will do.
Samantha Bee discusses the GameStop story and how it reveals how the system is so rigged that it is long overdue for regulatory overhaul.
Stock is a claim on or share of a company’s future profits. If a company makes money, it will either invest it into the company to make it more profitable in the future, or it will pay it out to its shareholders as dividends. These dividends give stocks a big part of their tangible value. If a share of stock pays out $5/year in dividends, maybe that justifies a price of $100 for the stock. I make $5 every year, and I can always sell my stock for $100. If interest rates are low, maybe I can’t make anything close to 5% interest at the bank, so I’m willing to pay $200 for that stock. The price/earnings ratio is based on arguments like this. Over the long term, if you invest in a big mixture of stocks, you might expect to make something like half your profits as dividends and the other half from the values of companies going up as they reinvest in their businesses.
That said, trying to make money from individual stocks is generally a fool’s game. You’re betting that you know more about either the short-term behavior of other investors (if you’re playing the day-to-day market) or the long-term potential of the company (if you plan on keeping the stock for a while) than most other people playing the market. Most people aren’t that clever or have that much foresight, so they should stay out of this game. That doesn’t mean you should stay out of stocks. It means you should buy low-cost index funds that track the market at almost no management cost to you.
“The price of a tangible object like a car, for example, would be roughly based on the cost of the raw materials plus the cost of the labor that went into its production plus the overhead costs plus the profit, with the sum total divided by the number of cars that are produced. ”
No, no, no. That’s the way rational people think. Our capitalist consumer society is not controlled by rational thoughts. Things are priced by whatever you can get for them. And cars are a perfect example of that. When most people buy a car they are not just buying a mode of transport. They are making a statement about how they want others to see them.
If cars and trucks were purely rational in terms of design and sales, we would never see SUVs with giant chrome rims and super low profile tires. That makes no sense for what is purported to be a “sport utility vehicle”. Likewise, the vast majority of small SUVs and hatchbacks would not have roof racks because the vast majority of people never use them, but they send a message of “I must be a rugged individualist because I need a roof rack to hold all of my outdoorsy gear”. What these vehicles would have instead is tie-points (basically captive nuts on steroids). They disappear if you don’t need a rack, and if you do need a rack they allow far greater flexibility than factory rails. And they’re also cheaper to manufacture and produce no added wind resistance when not in use.
Venkataraman Amarnath says
Tesla’s market capitalization (or total value) is – more than Toyota, Volkswagen, Daimler, General Motors, BMW, Honda, Hyundai and Ford combined. How many Teslas are on the road?
From the OP: “I was listening to an analyst who was saying that the people who are driving up the price of the stock may themselves end up losing a bundle. ”
I don’t think a lot of these people care about making money, which is super confusing to analysts. They seem to be more concerned about messing with hedge funds, and I suppose, making a statement about Wall Street and the market in general. I mean, they could sell right now and make a ton of money -- if that was the point. But they are not selling and instead telling each other to hold the line. I think for them it’s the thrill of watching hedge funds lose more money every day.
“telling each other to hold the line”
“Hold the bag”
With regards to art (or any sort of ‘collectibles) the usual line is that investment in it is based on the ‘greater fool principle’.
In order to make money, you have to find somebody who is a greater fool than you were when you bought it.
Canadian Steve says
That’s the theory, but the reality is that this is only a small piece of the stock market. Even if the stock market were limited to only basic stock investments there would still be the swings due to undeserved hype or negativity unrelated to the actual performance of a company.
Now add to that all the variety of bets (hedges, derivatives, stock printing for compensation, hostile acquisitions, etc) that go with this, and the market becomes completely detached from the underlying concept. The connection between company performance and stock price has been almost entirely decoupled, as proven by the redditors.
Just an Organic Regular Expression says
There is a minority school of investing called Value Investing (wikipedia link). Best known of this school in the popular imagination is Warren Buffet, but there are several other successful investment-management firms that follow this philosophy.
Value investors do careful research on not only a company’s tangible assets, but the quality and execution history of its management team, its position in its market, and other intrinsic factors. They look for companies that are under-valued by the market compared to their analyzed value. This can often happen; fundamental to Value Investing is the idea that the market is not consistently rational but often temporarily under- and over-prices companies. Value investors buy (what they deem to be) under-priced stocks and hold them, even if they go down; indeed if they go down, the value investor who has faith in their own analysis, may buy more shares.
So if you wanted to put some money in the market, you could find a manager that follows the Value, or Graham-Dodson, investing philosophy, and put your money with them.
I repeat: the value of financial shares is determined by supply and demand. The rest is baked air, including the comments above.
“The professionals in this business act as if they know how …..”
Repeat: baked air. A few decades ago Swedish newspaper Expressen has given five professionals and chimpanzee Ola 10 000 Krona’s to invest on the stockmarket. Ola did best … by throwing darts to listings of company’s shares.
There is still a good reason to invest in shares: because you think a company does good work.
John Morales says