Secrets of Investing: What’s the Fair Price of a Stock?

October 12, 2023

Every product has a certain value. Stocks are a product just like anything else. Sometimes, the value of a product can be calculated and determined in a fair, objective, and unambiguous manner, and sometimes not. There are a few problems with that.

For example, it is impossible to calculate the fair value of an ounce of gold. One can only determine its current market price, but is that always the real, fair value of the metal? What does “fair value” even mean?

If an ounce of gold cost $1,900 in 2011 and only $1,000 four years later, which of those values was fair? Or perhaps neither was? Maybe the fair value lies somewhere in between? How can it be estimated? How can it be calculated? How can it be verified?

According to some experts, gold will soon be worth $10,000, while others believe it will only be worth $800, which is the real cost of producing the metal. So, who is right here, and why would anyone want to pay more for an ounce of gold than the cost of its extraction plus the seller’s margin?

Houston, We Have a Valuation Problem

Other assets whose price depends on buyers’ current mood are also troublesome to value them right.

How can one determine the fair value of a single Bitcoin? Why did Bitcoin cost $1,000 in 2017 but $20,000 in 2018, and $3,500 in 2019? As I we this, Bitcoin is worth $27,000, but by the time you read this, the price will certainly be completely different – maybe $20,000, maybe $30,000. The question is, which of these amounts is, was, or will be fair, and what is the real intrinsic value of a single virtual coin?

What about the fair value of music sheets produced by Johann Sebastian Bach many years ago? The fair value of a painting? The value of a bottle of wine? A vintage car? Copper? Cobalt? The current price of these assets is what consumers, clients, recipients, or the entire market agree to pay for them at a given time.

Nevertheless, the transaction price has nothing to do with the value of the given item. The transaction price is determined by sentiment, advertising, whisper marketing, positive or negative public relations, authoritative opinions, and above all, the transaction price of gold or Bitcoin is determined by the ton of information in the evening news and morning press.

However, without knowing the fair value of a given product, we cannot determine whether the current transaction price is justified, or whether its current height is just a product of collective madness, panic, greed, fear, or euphoria or a newly emerging paradigm.

This is a big problem because there is no way to calculate and determine the fair value of a commodity that does not generate any cash flows. In such cases, the current value is determined by supply and demand, which, in turn, depend on so many different and dispersed factors that it would be extremely difficult to try to forecast them effectively.

A fair value expressed in currency can only be assigned to a commodity that also generates some units of the same currency.

Gold, Bitcoin, a painting, or copper do not generate cash flows, so there is no way to determine their absolute, real, fair, or intrinsic value (regardless of which synonym we choose to call it).

Goods that do not generate cash flows are worth only as much as consumers are willing to pay for them at a given time. The problem is that consumers’ opinion can change from minute to minute, and crowd behavior cannot be predicted.

The principle of making money, not just on the stock market, always remains the same: buy low, sell high. However, this task will be entirely impossible in an environment where there is no way to determine what is “expensive” and what is “cheap” for a given commodity.

Fortunately, stocks are different.

That Being Said…

Each public company generates some revenue. Most companies also generate net profit, which leads to real cash inflows into the company’s accounts. Quite a few businesses later allocate part of this cash to pay dividends to their shareholders.

Each of the above values (revenues, profits, cash flows, dividends) is expressed in the same units as the transaction price of the company’s shares on the public stock market.

This significantly simplifies the task of determining what price per share in a specific company will be a fair price. Even if the term “fair price” can be treated quite subjectively, comparing the valuations of different shares will already be a fully objective activity.

This is because we compare values expressed in identical units. We pay in US dollars for a company’s shares on the stock market, the shares then generate revenues and profits also expressed in dollars, and then these dollars are paid out in the form of dividends.

Thanks to this, we can easily indicate how many dollars we need to pay today for a single share of a company that will generate a specific part of revenues, profits or dividend payments on our share in the future. The task is simple because we compare dollar to dollar.

Let’s take the hypothetical example of two different companies, ABC and CAB, whose shares cost exactly 100 USD each. At first glance, one might conclude that since both securities cost the same, both shares are worth the same. However, such reasoning is flawed.

In reality, we should check what we get in return for our invested 100 USD. If it turned out that ABC generates 50 million USD in annual revenues and 10 million USD in profit, and also pays 2 USD in dividends per share, while CAB generates 100 million USD in revenues, 20 million USD in profits, and pays 4 USD in dividends per share, it quickly becomes clear that CAB’s shares are worth twice as much as ABC’s shares, as we receive twice as many benefits from the company.

Another issue is determining whether 100 USD for such a share represents a fair price, but we will deal with that later. At the current stage, however, we can certainly state that if we had to choose what to spend our 100 USD on, we would definitely prefer to buy CAB shares rather than ABC shares on the stock market, because in that case, we would get twice as many benefits for the same price.

Making this comparison is possible because we compare cost and benefit expressed in the same currency units, providing a point of reference.

Everything is Relative

A reference point is always needed to assess whether stocks are expensive or cheap, as their current market price alone has no meaning at all. One can never consider changes in stock prices in markets without being aware of the context. When assessing whether a stock is cheap or expensive, one should not just consider its transaction price, but instead ask: what do we get for this price?

If I were to ask random people on the street whether $20,000 is a lot, most would probably agree that the amount I mentioned is significant. However, let’s think about it.

The concepts of “a lot” and “a little” are relative, meaning their definitions will change depending on the reference point.

$20,000 for a brand new Mercedes straight from the dealership would not be a lot – one could even say it’s a great deal. However, $20,000 for a used five-year-old Dacia Logan from a shady dealership on the outskirts of town is quite a lot. Two completely different conclusions, yet we’re talking about the same amount.

The matter of reference point.

Incorrectly chosen reference points can also cause problems. Many investors, for example, look at the stock’s price history and compare it to the current stock price. If today’s price is above the average price from the last period, it means it is expensive; if the current price is at the bottom, detached from the old price, it means the stocks are cheap.

We have some progress in reasoning here, but unfortunately, this assumption also turns out to be wrong. Very wrong.

Why Doesn’t History Make Much Sense?

Imagine the shares of company XYZ, which cost $50 a year ago, and now cost $100. Is it justified to say that the shares are twice as expensive today as they were a year ago? At first glance – yes, but what if the revenues, profits, and dividends paid by the company have increased fivefold over the year? Can we say that the shares are twice as expensive, even though for twice the price, we get five times more benefits?

What if the company generated $2 of profit per share a year ago, and today it generates $10 of profit per share? In the past, by paying $50 for a share, investors acquired the right to receive $2 of profit, in other words: they had to pay $25 for $1 of profit. Now they have to pay $100 for a share (twice as much), but that share generates $10 of profit for them, so they currently only pay $10 for $1 of profit. More than twice less.

It can be confidently stated that despite the transaction price of shares increasing by 100% over the year, in reality, the shares are twice as cheap as they were a year ago!

This relationship is evident in the behavior of dynamic company stocks such as Amazon or Google, whose market prices have constantly been climbing at double-digit rates annually for years. Many outsiders cannot help but wonder how it is possible that there are still so many naive investors on the stock market willing to pay more and more for the shares of such companies. However, these investors are not naive – they simply pay more for the shares because they receive more revenue and profits in return.

If we only consider the change in stock prices on the stock market, we will never have a complete picture of the situation. The change in price and its level have absolutely no meaning until we ask what we get for that price.

In the case of stocks, the only thing we can get in exchange for buying shares is participation in the company’s revenues, which are then responsible for generating profits, which often translates into the payment of dividends. As long as these values are expressed in identical units (in some currency), it is quite easy to determine the real value (or otherwise: internal) of a share, because somewhere there is a limit to how many dollars we are willing to pay for a share that will bring us a specific number of dollars in the form of profit or dividends. The whole trick here is that we compare the dollar we have to pay today with the dollar we will receive in the future.

When investing in other financial instruments (gold, cryptocurrencies, commodities), this is impossible. After all, what do we get in exchange for an ounce of gold? Gold does not generate any cash flows. Some argue that by buying an ounce of gold, they are buying a sense of security. At the psychological level, such an approach is of course justified, but at the economic level – how can we calculate how many dollars a unit of “sense of security” is really worth?

This can only be done based on subjective feelings or emotions, and wherever subjective feelings and emotions come into play, it is difficult to talk about professional trading on financial markets.

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