It’s common for investors to tie a stock’s price to the success of the company, but in reality it moves based on the desires of investors (i.e. the popularity of the stock) — a more popular stock has a higher price than a less popular one.
A more functional way to view the price of a stock in relation to the value of a stock is to think of an individual stretching a rubber band; the rubber band can be pulled up or down (stock price up or down) based on the preference of the individual (investor preference/popularity), but the rubber band eventually returns to its original shape (return to the stock’s true value).
So as the stock’s true value moves higher or lower you can think of the stock’s price as oscillating around the value (above, then below, then above, then below, etc.).
When looking at any particular stock, one should always be thinking of its value and price at the same time, as they can often be significantly different and moving independently of each other.
Differences Between Value and Price
Investors often think that when the price of a stock goes up that the fundamental value of the stock is higher, but in reality the value of the security and the price of the security are often not in sync.
The price is what investors commonly look at — it’s the dollar amount listed on the stock exchange. However, the value offers a view into the fundamental nature of a company based on its assets and liabilities, such as its buildings, machinery, raw materials, inventories, debts, etc. and the stream of cash flows that investors should expect to receive in the future; it can be calculated in may different ways (price/equity, price/free cash flow, price/book value, etc.) and each valuation method has it’s own usefulness.
The important idea to grasp is that when a stock price moves up or down the value of the company may or may not be moving in the same direction.
In section 1 of the chart above, the price of the stock listed on the exchange is high but the stock’s underlying value is low; if you purchased the stock at this point it would be the equivalent of buying any overpriced item — the price that you are paying is higher than what the item is worth. In section 2, the price and value are now equal and they move along in tandem for a while. Then the value of the company rises and the price falls and in section 3 the price is lower than the value of the company; if you purchased the stock at this point you would be paying less than the actual value of the company.
Since the price of a stock moves based on investor preference (i.e. popularity), investors often purchase the stock of a company that they like, instead of a company that is “worth the purchase price”.
The future price of the stock (your future return) depends on the price that you pay for the stock. In other words, a successful company — one that you like — is not always a good investment (a successful company could continue to sell their product and the stock price may not go up). This is why you should always be aware of the reality of value and the ephemeral nature of price.
Why price moves up or down?
Try to think of securities as animals in an enclosed pen on a farm, each with a different owner. Cattle, horses, chickens, etc. — each represent a different security that is traded (stocks, bonds, cash, etc.). At any one point in time the ownership of the individual animals changes, but only based on how desperate the owners are to own one particular type of animal. For example, if most of the owners want cattle and horses (stocks and bonds), they’ll have to trade more chickens (cash) than normal to get them. In this case it costs more chickens for cattle and horses, so it costs more dollars for bonds and stocks; this means the price of cattle and horses is higher than before merely because they are more desirable! The change in the price of a security is merely an indication of the new aggregate desirability of the security — its popularity.
In another example, if most of the owners want to get rid of their cattle and horses (stocks and bonds), then they’ll need to accept a lot less chickens (cash) to do so. In this case, the price for cattle and horses is lower than before (investors accept less cash for their stocks and bonds, and thus the price of stocks and bonds are now lower than before).
The important idea to think about is the fact that, at any one point in time, aggregate ownership of any asset class is stagnant — it’s not higher or lower. If you ever hear or read that “ownership of stocks is low” or that there is a lot of “cash on the sidelines”: RUN, because it can not happen. It is possible for one small group (i.e. non-aggregate ownership) to be tilted to one asset class, but this also means that another group has an opposite ownership. For example you could say retail investors have more cash and less stocks, but that means that institutional investors have more stocks and less cash. Total aggregate ownership of securities is stagnant; individual securities are traded back and forth between individuals, their prices spiral up or down based on investor preference (popularity of the security), yet the securities simply change hands for a different price — the aggregate ownership of the securities does not change.
Stock ownership summarized:
“Simply put, every security that is issued has to be held by somebody, in exactly the form it was issued, until that security is retired. If the Federal Reserve effectively retires $4 trillion in government bonds from public ownership, and replaces them with $4 trillion of currency and bank reserves, somebody has to hold that cash, in that form, until it is retired. There is no such thing as this money going “into” the stock market. If a buyer comes “into” the market with cash, the cash goes right back out an instant later in the hands of the seller. Likewise, if trillions of dollars of low-interest Treasury bills, low-yielding corporate debt, and other securities have been issued, those securities have to be held by somebody, in exactly that form, until they are retired. One can call all of this low-interest paper “cash on the sidelines” if one wishes, but the essential fact is still that those securities will never come off the “sidelines” until they are explicitly retired. Until then, they must be held by someone, at every moment in time, in exactly the form in which they were issued.
Stock prices don’t go up or down because money goes “into” or “out of” the market. For every buyer, there is a seller. Every dollar that comes in goes out. All that matters is who is more eager — the buyer or the seller. Speculative yield-seeking has certainly produced eager buyers, who have driven virtually every asset class to nosebleed valuations and dismal prospective future returns. At present, zero interest cash is quite competitive with risky assets, so be wary of the assumption that just because cash earns virtually nothing, any risk asset offering a yield must be dominant. Again, yield-seeking only “works” as long as investors imagine away the risk of capital losses.”
– John P. Hussman, Ph.D. (from his July 18, 2016 weekly market outlook entitled Scrounging Through the Dumpster)