Does Valuing All of a Firm's Stock at the Market Price Badly Understate the Firm's Market Value?
By:
No, according to economist Jeffrey Rogers Hummel.
In a recent email discussion one economist claimed that we should be wary of measuring a firm’s value by multiplying the number of the firm’s shares by the price per share. His point is that the price of the firm’s shares on the market gives only the marginal value, the value that someone just barely willing to buy will pay. There are likely many shareholders, he argued, who value the firm’s shares they hold above the market price. What’s the evidence? Their behavior: they’re not selling. [I’m not quoting this economist’s name because I don’t have his permission.]
He makes a good point. But how much above the market price? Jeff Hummel argues that it’s not necessarily that much. I was thinking the same thing for the same reason Jeff gave, but he stated it much better than I had done in my mind. Here’s Jeff’s response:
I agree that the total subjective value of the stock of a particular good must exceed its price (marginal value) times quantity, as Warren points out. But the amount by which total value exceeds market value depends on the elasticity of the stock demand curve. In the case of housing, as Mark points out, there is probably a significant difference. But with respect to financial assets I think you push this point too far.We don’t have to go to the rational-expectations extreme of assuming that demand curves of financial assets are perfectly elastic to conclude that they are nonetheless probably quite elastic. After all, the primary reason that nearly all investors hold financial assets is because of their expected future returns. Financial assets are not like consumption goods, such as CDs, ice cream, or water, cases where some consumers subjectively value the goods way above their market price or where the first unit provides far more direct utility than the last unit. Thus I suspect the total value to investors of a company’s shares should not be significantly greater than the sum of the shares’ market value.I think Warren’s example of a hostile takeover actually illustrates my point. A takeover is attempted only when investors believe that new management can raise the present value of a corporation’s future earnings. These investors therefore must consider the shares to be properly priced under existing management. And even if there is significant variation in the subjective value of shares to shareholders, market value still gives the best available estimate of the present value of the shares’ future earnings.Which is why I also question the importance of Mark’s point about competing views of the future. That is not the only reason, nor even the most common reason, that investors choose one financial asset over another in their portfolios. Nor are the plans of different companies always incompatible. Indeed, much of the time their plans complement each other. True, in the future some companies will suffer losses, while others will earn pure profits. And one or the other will sometimes predominate. Financial assets seem to have been overpriced on net during the housing boom and then underpriced on net during the financial panic. But often, the errors in either direction should cancel each other out. So I think using market prices to estimate total financial wealth still provides a good approximation.
READER COMMENTS
Matthias Goergens
Aug 11 2018 at 10:28pm
If someone found better estimators for the proper average value of shares than their marginal value (ie traded prices), couldn’t they make money trading on that?
Thus this is also a discussion about stock market efficiency. (And those trades would feel very familiar for value investors.)
David Henderson
Aug 12 2018 at 10:41am
If people find that their value exceeds the market price, they should become owners, or remain owners, of the shares.
robc
Aug 13 2018 at 12:24pm
If someone found better estimators for the proper average value of shares than their marginal value (ie traded prices), couldn’t they make money trading on that?
Isn’t that exactly what is done everyday? Or at least attempted.
Joseph Ajram
Aug 18 2018 at 5:08am
So you find a better way to value a company, more accurate…if buyers and sellers disagree, how can you make profit of that? theoretical value and market value are different and this is why we have trading and financial markets.
Thomas
Aug 11 2018 at 10:30pm
Huh? Since when is the value of something determined by the price being asked (or not asked) by the seller?
The value of a firm is determined when it is sold — lock, stock, and barrel — by a willing seller (e.g., management acting on behalf of shareholders) to a willing buyer. What I would like to see is data for the per-share value of firms that have been sold to the firms’ price-per-share in the period immediately before there were rumors about a sale.
David Henderson
Aug 12 2018 at 10:40am
You write:
The value of a firm is determined when it is sold — lock, stock, and barrel — by a willing seller (e.g., management acting on behalf of shareholders) to a willing buyer. What I would like to see is data for the per-share value of firms that have been sold to the firms’ price-per-share in the period immediately before there were rumors about a sale.
Sure. But that happens rarely. Many of us want a quick and dirty of a firm’s value. The stock price times the number of shares is such an estimate. It’s an underestimate, to be sure, but Jeff’s point, and mine, is that it’s not a huge underestimate.
Kevin Erdmann
Aug 12 2018 at 12:15am
Sorry. This is a bit pedantic, and maybe off-topic. But, I think the comment about housing being different is an important topic. I think that comment is wrong, and it has to do with the conventional way of thinking about owner-occupiers as consumers who pay for their housing by buying it, rather than thinking of them as having two roles – a tenant and an investor.
I think that the reason we imagine that home prices can veer wildly from marginal value is because of issues like an endowment effect, where the occupants value a home at much higher than market value, and are less likely to sell when prices rise. But, in this case, the lack of a selling response comes from their position as tenants, not from their position as investors. The don’t sell because, to them, the rental value is higher than the market rent.
So, in the comparison from the post, what we are really doing here is backing this concept up one more step and saying, “Well, some consumers of the firm’s products value them much more than the products’ prices, so the firm can be worth much more than the market value if we factor that in.”
Firms don’t usually have as much monopoly power to extract profit from their products as an owner-occupier has to extract rent from themselves. Maybe an analogy is price discrimination in airlines. The prices of each ticket on planes vary widely according to how much consumer surplus they manage to extract. But, the market for the airlines themselves doesn’t behave the same way.
In the same way, families might be tethered to homes in ways that create large variances in their reservation rental values. But, this doesn’t necessarily mean that home market values across time should have such variance. Just because you hear that one businessman had to spend $1,000 for a last minute ticket doesn’t mean you should plow your savings into airline stocks, because there are many things happening on the margin across airlines and across housing markets, even when within those markets there are individual variances.
Like I said, maybe this is pedantic, but I think it creates terrible policy biases where liquid markets in housing aren’t allowed to form because lumping together tenancy and ownership leads to an overestimation of inefficiencies in the purchasing market. Liquid marketplaces are very important. In both markets, support for liquid marketplaces is eroded when those marketplaces are believed to be arbitrary. Liquid marketplaces for housing have been severely compromised because of this rhetorical tendency.
David Henderson
Aug 12 2018 at 10:37am
Kevin,
I think it is off-topic, but I didn’t find it pedantic.
Jeff Hummel
Aug 12 2018 at 1:29pm
@Kevin
Excellent point! I’m convinced by your analysis. Thanks for the correction.
Kevin Erdmann
Aug 12 2018 at 2:49pm
Thanks for the feedback!
David Henderson
Aug 12 2018 at 3:40pm
Jeff, What was the correction?
Philo
Aug 12 2018 at 12:48am
I don’t get it. “There are likely many shareholders, he argued, who value the firm above the market price. What’s the evidence? Their behavior: they’re not selling.” But there are even more observers who value the firm’s shares below the market price. The evidence: they’re not buying (and a few may even be selling short).
David Henderson
Aug 12 2018 at 10:36am
Philo,
The line you quoted was incorrect. Here’s what I should have said: “There are likely many shareholders, he argued, who value the firm’s shares they hold above the market price.”
You write:
But there are even more observers who value the firm’s shares below the market price. The evidence: they’re not buying (and a few may even be selling short).
True, and irrelevant.
Philo
Aug 15 2018 at 3:49pm
Why irrelevant? You seemed to be saying: “The marginal shareholders value each share at the market price, but we can’t just accept their evaluation: we must also consider the evaluation of the infra-marginal shareholders, who have a higher valuation for the shares.” But if we are going to give weight also to the views of these people, should we not go further and give weight to the views of the non-holders and short sellers: why disenfranchise them?
Philo
Aug 15 2018 at 11:54pm
I think you are imagining a situation in which the holder of, say, exactly 100 shares of stock in a particular company places different values on his different shares. Let’s say the shares are changing hands in the market at $10 apiece. The stockholder may value his first share at $12. Now, if he also valued each of his other ninety-nine shares at $12, then presumably he would also value a potential 101st share at $12. Since he could buy this extra share for $10, he would do so; so he would not, contrary to our assumption, hold exactly 100 shares. It must be, then, that he values shares after the first one less and less, down to a value of $10 for the hundredth share, and slightly less than $10 for a potential 101st share. But normally the shares in a particular company are perfectly fungible, and so should be considered equally valuable. So your imaginary investor’s attitude is paradoxical.
David Henderson
Aug 16 2018 at 6:20pm
There’s no paradox. Whether we’re talking shares in corporations or tacos, they can be identical (shares with each other or tacos with each other) but we still have downward-sloping demand. Indeed, the way economists discuss diminishing marginal value is by talking about additional units of the exact same good. We’re getting far afield though because, let’s not forget, the whole point of this post is that the demand for shares, unlike the demand for tacos, is very elastic; that is, the demand is only slightly downward-sloping.
Alan Goldhammer
Aug 12 2018 at 7:45am
I find it very difficult to understand the quoted material when it is taken out of context from the full discussion. While some of this may make sense from an economic perspective I’m unsure about how much is relevant to investing which is my primary concern. Future earnings while important are notoriously hard to predict and depend on multiple variables (look at what is happening to some companies right now because of the steel and aluminum tariffs), not to mention corporate structure (remember Enron who were projecting future earnings in a manner that was completely removed from reality?). From a Graham/Dodd perspective, intrinsic value is far more important.
“A takeover is attempted only when investors believe that new management can raise the present value of a corporation’s future earnings.” This is not completely true as there are multiple examples of private equity buy outs of companies with debt financing pretty much destroyed any chance of improvement in the earnings position of the ‘re-launched’ company as it was unrealistic to expect that the debt payments could be covered by earnings. The private equity folks didn’t care about this aspect as they got their money up front. Certainly mergers in the oil industry over the past forty years have been largely successful but is there another industry sector that one can point to where there has been as much uniform success? One other comparable industry consolidation is the airline sector but I’m unsure whether this can be deemed successful from an investing perspective.
Dylan
Aug 12 2018 at 8:58am
In the title for the post, should it read “understate” instead of “overstate?” I get that the logic is the same for either, but all the discussion is around the value potentially being larger than the market cap, not smaller. Although when I’ve seen this argument before, it has gone the other way arguing that market cap, especially on companies with a low float, does overstate the value of the firm. The idea being that if the majority owner tried to sell a substantial portion of their shares, the price would decrease with the increased supply.
David Henderson
Aug 12 2018 at 10:44am
Dylan,
Thanks. Good catch. Corrected.
JFA
Aug 12 2018 at 10:08am
What you want is evidence for what happrns when one firm buys another or when a public company takes itself private. My sense is that the market value given by shares is lower than what is given when those stocks are bought en masse. But since there is no evidence given in this blog post, I guess I’ll have to withhold judgment. I’m sure someone has written a paper on this. Maybe something a retired professor has time to find. 🙂
David Henderson
Aug 12 2018 at 10:46am
@JFA,
My sense is that the market value given by shares is lower than what is given when those stocks are bought en masse.
True. But ceteris isn’t paribus. There’s information about values implicit in the action taken. The market is saying that the value is higher than we thought, probably because the new owner is expected to do a better job.
Dylan
Aug 12 2018 at 2:11pm
@David,
But doesn’t the trend hold for management buyouts as well? Elon Musk couldn’t take Tesla private at the ~$350 a share or so it was when he made the “announcement,” he had to offer a premium. Same for when Michael Dell took Dell private. No management changes expected because of these deals, the only change being that they are now private and supposedly not subject to the same short term whims of the market. But if that was universally the case, we would expect to see companies have to take a lower valuation when going public than they had when they were private, which is not something we normally see.
Robert EV
Aug 13 2018 at 4:21pm
I don’t quite get what you or David are arguing here, but isn’t some of the increase in price to take a company private also due to:
The stockholders demanding a premium for losing liquidity.
The stockholders shaking down the parties which want to take the company private for everything they can (akin to sunk cost fallacy in haggling and gambling).
?
Robert EV
Aug 13 2018 at 4:26pm
Specifically for those going private with the new owners: They now can’t easily sell their shares on the market.
And for those selling their stocks at the buyout premium: They now have fewer opportunities for stockmarket investment (as they’ll have to buy shares of other companies if they want to keep the money passively invested, which means bidding up prices of those other companies’ stocks beyond what the market currently values them at [more money chasing fewer opportunities]).
Michael Sandifer
Aug 12 2018 at 1:33pm
I would also point out that in the case of a buyout attempt, new information is introduced in terms of demand for the stock.
David Henderson
Aug 12 2018 at 3:41pm
Right, Michael. That’s the point I made in my response to JFA above.
Charlie
Aug 16 2018 at 5:37pm
The problem with the new information theory is that bids well above market value are sometimes rejected and the stock does not rise to that bid.
A stock might be trading for $10 and an acquirer bids $13. This bid is sometimes rejected by the shareholders and the stock remains at $10. The investors in the firm (and potentially the acquirer) think the stock is more valuable than the marginal investor in the firm.
jj
Aug 13 2018 at 12:26pm
The financial value of a firm is almost certainly less than the shares-times-price value (unless we’re just arguing semantics of what ‘value’ means, and whose value we care about.)
Consider the distribution of the market’s estimation of a firm’s value, and assume that the center of the distribution is the true value. The marginal share price will be the upper end of the distribution, as these are the people willing to buy. How far down the distribution the share prices goes depends on the firm size and market size.
Of course the distribution needs to be weighted towards those who actually put money on the line, but when the firm size is small relative to the potential pool of buyers, I don’t think that changes things much.
On preview: Philo’s comment is another way to say the same thing, that market participants who choose not to buy are providing information about the firm’s value.
Robert EV
Aug 13 2018 at 4:04pm
You forget to count those who continue to own shares simply through sentimentality, inertia, ignorance, or the time and annoyance cost of selling the shares that they would otherwise believe are over-valued.
David Seltzer
Aug 13 2018 at 5:04pm
David, I tend to agree with Hummel as to price/value parity. The Market price is pretty close to market value just from an arbitrageurs POV. If a firm’s book value exceeds its market value, buy the stock as it is really a call on the firm’s assets.
Floccina
Aug 16 2018 at 1:32pm
Aren’t there also effects from concentration. If large shareholders sell they will push the price down.
Charlie
Aug 16 2018 at 4:27pm
We have lots of data on what happens when someone wants to buy the entirety of a firm (every share) as opposed to just a small number. They are called takeovers or mergers and acquisitions. Most are not hostile (90+%).
What is the result? The average premium paid by acquirers is about 40%.
Evidence for the bid premium and hostile bids is in table one of this JEP paper:
https://pubs.aeaweb.org/doi/pdfplus/10.1257/jep.15.2.103
Euglossine
Aug 16 2018 at 4:44pm
I think it clearly underestimates the price established by that fraction of people who are current investors. If I own the stock, then I, by definition, estimate the worth of the company to be higher than the market price.
Some on this thread argue that this logically implies that if I were and investor I should buy more of the stock, since I think the current price is lower than the true value. However, this overlooks multiple extremely salient values. First, I have limited funds. Second, I value diversification. Third, I am aware that my estimate may be inaccurate and am essentially choosing an amount to bet on my belief.
However, overall, the true value of the company may be either higher or lower. If I, an informed investor, believe that the stock is overvalued, I may simply not invest — in all likelihood, this is the right course of action unless I also believe I know when I will be proven right. If the mistaken set of investors continues to disagree with me for too long, I will lose money. Betting on a company is much easier than betting against.
This is not a flaw. The purpose of the market is not to find the “true value” of a company but to provide initial capital for a company and to provide liquidity for those who own it. It’s an unimportant question — so is the true value of a commodity, say an orange. What matters is what price will enable all of the available oranges to be sold. If there were suddenly 1/2 as many oranges in the world, the price would rise. Perhaps the value of all of the remaining oranges would be just as high as the value of all of the oranges currently existing. (people do want their juice and only a fraction of the cost is in the fruit) This makes a mockery of divining the true value — 1/2 of the thing is just as valuable as the whole. And yet, it is quite possible given a particular balance of supply and demand.
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