What is the "fair" or "objective" price of a company’s shares? At first glance, the answer is simple. For example, the graph of Alimentation Couche-Tard Inc. (Cl B) below shows that the share price at the close on September 14, 2011, was $28.34. We must agreed therefore that this is the "fair price" of the stock, especially since 451,740 shares changed hands that day after a real struggle between buyers and sellers. The price is therefore considered right because it results from an offer that has met the demand throughout the day, resulting in a change in the price: As such the shares began the day at $28.06, touched a high of $28.55 and a low of $28.06, to close at $28.34.
Charles Dow, who co-founded the Dow Jones Industrial 120 years ago, said that the market constantly gives a "verdict" of all possible known aspects of each stock, including the psychological, social, political and economic environment in which the business operates, both domestically and internationallyfootnote 1 . When a stock changes price it is because the verdict has changed to reflect new information. So, in effect, an investor can simply overlay two moving averages on a stock chart; a long-term and short term. When they cross, it signals a change of direction – for whatever reason – and an investor can benefit by simply tracking the market.
This way of looking at the price of a security is rather passive. We accept that the price is objective and "fair" simply because it is publicly traded and has a high volume of transactions. We do not question it. Thus, the "market value" of ATD.B is $28.34.
One might ask why the stock of ATD.B costs less than $30, while that of Agrium inc. is $85.88. Compared to Couche-Tard, is the stock of Agrium expensive? The answer is no.
Two reasons explain this difference in price. First, the shares of Agrium are almost three times more expensive than that of ATD.B simply because there are fewer shares of Agrium than Couche-Tard outstanding. Indeed, the number of shares available depends on the number of shares issued by each company. This number was set and approved at the time of issuance. In short, the price of a stock reflects the overall value of the company divided by the number of shares.
A second reason is that the stock price has risen significantly. For example, XIU (the exchange traded fund that tracks the S&P TSX60) was trading at $32 per unit in 2002. Over the following years it rose steadily. In early 2008 it was trading at $88. We could not say that the units were expensive at that price; they were simply echoing the opinion of the market. That was their market value. But many investors had a difficult time putting money into XIU at this price. To buy 1,000 shares of XIU would have required an outlay of $88,000. They would have preferred to place a quarter of that amount in XIU and the remaining ¾ elsewhere. For this reason the issuer divided the securities into four parts (a split: See the XIU 10 year chart). In 2008, one $88 share became four shares worth $22 each. The total value had not changed. There were four times as many shares outstanding, but the aggregate dollar value was the same. It just become more manageable to invest in XIU.
Other ways to see if the price is "fair"
As accountants, managers and financial analysts will tell you; often the value given to a stock is not the right one. Indeed, a listed security may be undervalued or overvalued compared to the "objective" value calculated by these specialists, as investors reacted erroneously and emotionally to some news.
In this regard, if the market value of a security exceeds the value established by the accountants or managers, it should be sold. Conversely, if it is lower it should bought and held until the price reaches the calculated value, regardless of the changes in the direction of prices reflected by the two moving averages.
We calculate the book value of a share by dividing common shareholders' equity (total equity less preferred shares) by the number of shares outstanding. The common shareholders' equity reflects the book value of the company. The ratio obtained, that is to say the price of one common share is the fair value of the stock. Naturally, this "objective" value reflects only the situation of the company in terms of financial statements, disregarding any other factor. This means that the share price so calculated may be lower or higher than the market price, which also includes context and perspective. It is therefore possible that the book value of a stock differs from the market price. This price difference may vary considerably from one sector to another.
One way to use the market value and book value at the same time is to observe the ratio between the two. If this ratio is high compared to industry standards, we say that the stock is overvalued.
There is another, similar ratio which compares the market value of the stock to the total sales divided by the number of common shares.
Financial analysts and portfolio managers have their own approach in calculating the price of a share, which they refer to as its “intrinsic value”. Their reasoning is: “If today I deposit 100$ at the bank at 1% annual interest, I’ll have 101$ in my account in a year’s time. Over many years, even the past interest that I earned will earn interest”.
I can now make the opposite argument and say, for example, that the value of $101 in one year is $100 today. To find the intrinsic value of a stock we must answer the question: What is the present value of a security that pays dividends every year, in perpetuity? In other words, the present value of a stock is determined by the annual income of future dividends. The mathematical formulas give the answer.
If the company does not pay dividends, we perform similar calculations taking into account the profits of the business.
The intrinsic value of a stock is the value managers and analysts consider to be fair, even if different, in most cases, from the market value and book value.
The intrinsic value varies continuously because:
- Companies are not required to pay dividends, contrary to what happens for coupons on debt. So if the economic situation is bad, a company may suspend or reduce the dividend amount.
- In theory, dividends are expected to increase from year to year. At least that's what is expected as a company grows and profits increase. Analysts estimate a growth rate of dividends in advance, for years to come. Of course, they may have to adjust this rate by taking into account the conditions of the sector in which a company operates.
- A company may also pay dividends by looking at growth in increments. Thus, for a few years, the pace of growth may be fast and then slow down; or be slow and speed up after a while. Obviously, it is unlikely that one can reliably predict market trends.
- The same problem arises when calculating the intrinsic value of a share using future profits from the business.
- The intrinsic value of a security is based on probabilities that are subject to change, even in the short term, according to the market in which a company operates.
Part of the work of managers is therefore to buy and sell shares by adapting to the dynamics of change in the intrinsic value of securities selected.
Each of the three approaches to the evaluation of a stock - the market value, book value and intrinsic value - provides a "fair price" which differs from the other two. Each method has its logic and its application.
Which method is best for the private investor? Let us recall the words of Charles Dow: In the market value of a security, the price reflects everything, including conclusions about the book value and intrinsic value.
- Charles Dow’s exact words were, “In fact, the market reduces to a bloodless verdict all knowledge bearing on finance, both domestic and foreign. The price movements, therefore, represent everything everybody knows, hopes, believes and anticipates. Hence, there is no need to supplement the price movements, as some statisticians do, with elaborate compilations of commodity price index numbers, bank clearings, fluctuations in exchange or anything else. The price movements themselves reflect all these things, and therefore an understanding of the price movements of the market.”