Stock Prices
Ian
Lance
Taylor
http://www.airs.com/ian/
ian@airs.com
2003
Ian Lance Taylor
This document is licensed under a Creative
Commons License.
$Date: 2003/03/28 01:13:07 $
Prospectus from an anonymous entrepreneur who sold £2000 worth
of shares in this company before disappearing forever, in the year
1720.
A company for carrying on an undertaking of great advantage, but
nobody to know what it is.
Last changed on $Date: 2003/03/28 01:13:07 $.
This is a brief discussion of my thoughts on stock prices. This is
based on an e-mail message I wrote in early 2000, near the top of the
bubble. At the time it was clear to me that many people failed to
understand how stock prices really worked. Now that the bubble has
popped I think people have a better understanding of stock, but
perhaps some will still have something to learn here.
Note that there are plenty of smart people who disagree with the views
taken here, so don't take it too seriously. If you hurt yourself,
it's not my fault.
Some of this discussion is specific to the U.S.A. I'm not very
familiar with stock markets in other countries.
How Can You Make Money with Stock?
Most people buy stock in hopes that they will make money. There is a
great deal of opinion available as to which stocks will make money--on
the net, on TV, in books on investment. I believe that most of that
opinion is misleading.
It is misleading because most discussion of making money with stock
focuses on information which is not inherently important (e.g., P/E
ratio, technical analysis, etc.). I want to stress the word
inherently here. I'm not saying that this
information is not important; however, its importance is not inherent
in how stock works. It is important because it is important to other
people. It is not important in and of itself.
Stock prices are a consensual hallucination.
To see what I mean, let's consider the different ways stock can be
used to actually make money.
You can sell the stock to somebody else for more than you bought it
for.
Some stocks pay dividends. These are payments of cash or additional
stock made to existing shareholders. Many established companies pay
these quarterly. Many high-tech companies--the very companies which
led the recent bubble--do not pay dividends.
Occasionally a company will be purchased for cash, in which case all
existing shareholders of the purchased company will receive some money
based on the number of shares they own. (More frequently, companies
are purchased for stock, in which case shares of the purchasing
company are exchanged for shares of the purchased company.)
If you want to make money on stock, those are your only paths. You
can make it quite a bit more complex by using options and derivatives,
but these amount to different ways of betting on the movement of stock
prices. They don't get you out of the hallucination.
Dividends
Let's start with dividends. Occasionally people argue that the price
of a stock is based on the future dividends which it will pay, with
some discount rate applied because the money will arrive in the
future. This turns out not to be the case.
Purchasing a stock which pays dividends can be thought of as similar
to purchasing a bond which pays interest. In both cases you pay a
certain amount of money, and you periodically receive cash. A bond
typically has a maturation date, at which point you get back your
original investment (there are many variations which are not important
here). While stock does not have a maturation date, you can sell it
at any time, and hopefully recover your original investment.
The difference between stock dividends and bonds is, of course, that
bonds provided a guaranteed return on investment, and stocks do not.
A company may pay a smaller dividend, or it may stop paying dividends
entirely (or it may pay a larger dividend). When the bond matures,
you recover your original investment. If the stock price goes down,
you do not (or, if it goes up, you get more).
In short, bonds have specified behaviour. Stocks do not. (We'll
ignore the case of risky bonds, such as junk bonds; it's possible to
buy bonds which are clearly less risky than any stock, such as
U.S. Treasury bonds, backed by the U.S. government.) In other words,
stocks are more risky than bonds: there is a greater chance that you
will lose money. When one investment is riskier than another, we
normally expect the riskier investment to have a higher rate of
return. The higher rate of return compensates for the greater risk of
losing money.
The average yield on stock dividends over the last 80 years is 4.39%.
In other words, on average, if you bought stocks and never sold them,
it was equivalent to buying bonds which paid 4.39%. However, the
dividend yield has dropped steadily since 1982, down to as low as
1.07%. While it has rebounded slightly in the new millenium, it
remains below 2%.
By comparison, the yield of long term U.S. Treasury bonds since 1982
has been consistently over 4.5%.
In other words, these days, you can make more money investing in long
term U.S. Treasury bonds than you can from stock dividends, on
average. This hasn't always been true, but it has in fact been true
since about 1965.
This does not necessarily mean that bonds are better than stock.
After all, stocks can go up in price. What it means is that the price
of a stock is not based on the dividends which it pays. Paying
dividends probably increases the price of a stock. But if dividends
were a significant component of stock price, then the dividend yield
would be at least close to the yield on long term U.S. Treasury bonds.
And, of course, these days many stocks do not pay dividends at all.
This is further proof that stock prices are not based on dividends.
Company Purchases
It is conceivable that part of the price of a stock is based on the
possibility of a cash purchase of the company.
Companies do get acquired fairly often. However, most acquisitions of
large public companies are done using stock. Some price is set on the
acquired company, and the acquiring company issues that amount in
stock, based on the acquiror's stock price. That does not set a real
value for the stock price of the acquired company; it only sets a
value in terms of the stock price of the acquiring company. So this
type of acquisition does not help us see how stock prices are set in
general.
The possibility of a cash acquisition does set a lower bound on the
stock price. If the stock price of a company is low enough that the
total market capitalization of the company is less than the total
value of the company's assets, then it makes sense to purchase the
company for cash, and sell off the assets. This can be done even with
a very large company by borrowing the cash used to make the purchase;
this is called a leveraged buyout.
Moreover, if the company generates enough cash, it may make sense to
purchase the company for cash, keep running it, and simply collect the
profit. This is the underlying basis for the commonly cited P/E
ratio, which divides the price of the stock by the company earnings
(i.e., net profit). If you assume that earnings will hold steady (not
generally a safe assumption) then a P/E ratio of 15 implies that for
an outlay of $15 you could get $1 each year, which is a return on your
investment of 6.67%. Of course, buying a company would be a
relatively risky investment. Still, this suggests that a company with
a low P/E ratio is a candidate for an aquisition, and might therefore
be a good investment (because the acquiror will normally have to pay
somewhat more than the trading price to buy up all the shares).
In fact, the average P/E ratio of the overall stock market over the
last 80 years was 15.7. On June 30, 2002, the average P/E of the S&P
500 was 37, roughly equivalent to a return of 2.7%. So even after
much of the bubble has popped, we see that the P/E ratio currently
predicts a return which is less than that available from long term
U.S. treasury bonds.
The historical figures suggest that the P/E ratio can be used to set
the real value of a stock, assuming you take into account other
factors like the stability of the company. On this assumption, stock
prices are still far too high, and they will inevitably continue to
fall.
However, this is misleading. Somebody who focused only on P/E ratios
would have missed the entire stock bubble from 1996 on. They would
have refused to buy stocks even as share prices were going up, and
they would have missed the chance to make a great deal of money by
selling before the bubble collapsed.
The P/E ratio does give an approximate lower bound on the price of the
stock. A company with a very low P/E ratio is a potential takeover
target, and therefore a potential good investment. However, the P/E
ratio does not give the correct price of a stock because it does not
set an upper bound on the price. The upper bound on the price is set
only by the willingness of people to buy the stock. This was clearly
shown in the recent bubble.
Thus we see that while the possibility of a cash aquisition does
permit us to set a lower bound on the stock price, it can not be used
to determine the real stock price itself.
Selling Stock
So far, I have argued that dividends and potential acquisitions are
not significant components of the price of a stock, at least not given
present stock prices. However, people clearly do buy stocks, and they
clearly do expect to make money by doing so. There is only one way
they can make a reasonable return on their investment: by selling the
stock to somebody else at a price higher than they bought it for.
Let's take a moment to think about this. Suppose you buy a share in
the Frobozz Stock Company for $10. You could have put that $10 in a
savings account, or just bought a pizza, but you didn't, so you would
eventually like to get more than $10 from your share. The only way
you will do this is by selling your share to somebody else for more
than $10 (in fact, you want to sell it for more than $10 plus the
interest you could have gotten in a savings account, or a bond, or
whatever).
You might think that the Frobozz Stock Company is a good investment
because it has two "z"s in the name (bear with me for a moment). When
you go to sell it to your friend Adam, you'll talk about what a great
buy it is because it has two "z"s. Unfortunately, he might not care
about "z"s. You would have to find somebody who does care.
Or you might think that the Frobozz Stock Company is a good investment
because it has a low P/E ratio compared to its competitors. When you
go to sell it to your friend Beth, you'll talk about what a great buy
it is because it has a low P/E ratio. Unfortunately, she might not
care about P/E ratio--just because it makes sense to you doesn't mean
that it makes sense to her. You would have to find somebody who does
care.
As it happens, a lot of people do care about the P/E ratio of a
company. But we can see that the only thing which really matters
about stock price is whether you can convince somebody else to buy it
from you at a higher price. The P/E ratio does matter. However,
assuming the stock price is above the lower bound discussed above, it
only matters because it matters to a lot of other people. It is just
an agreed convention for setting the stock price.
If everybody suddenly stopped caring about the P/E ratio, and instead
started caring about, say, the number of "z"s in the name, then stock
prices would shift. They would shift because people would be willing
to pay a higher price for some stocks, and a lower price for others.
But nothing about the companies involved would have changed. The only
thing which would have changed would be people's perceptions of how
stock prices should be set.
This is what I mean when I say that stock prices are a consensual
hallucination. The things which matter in setting a stock price only
matter because many people think they matter. If people changed their
minds about what mattered, stock prices would change, even if nothing
else changed.
Owning a Company
Before I wrap up, I want to briefly discuss another aspect of stock:
ownership. Owning stock in a company is often described as owning a
portion of the company. It is possible that this ownership is
desirable, and should be part of setting the stock price.
Unfortunately, the notion of owning stocks as owning a company is
misleading for ordinary small investors. If you do not own a
noticeable percentage of a company, the things you can do are, in
practice, limited to:
Writing proxy proposals, which are voted on once a year at the annual
meeting.
Voting on proxy proposals written by shareholders or management.
Voting for the members of the board of directors.
This is, in theory, real power. In practice, a significant number of
the shares of any given large company are held by management and by
large investors who tend to vote with management. It is difficult,
though not wholly impossible, to pass a proxy proposal over management
objections. Moreover, since proxy proposals are only voted upon once
a year, they are a very blunt instrument.
Voting for the board of directors seems promising, but most companies
offer only one choice for each position. It is possible to write in
somebody else, but only a very well-funded opposition candidate is
likely to be able to reach and convince enough shareholders to get
elected. It's very unusual for anybody other than the management
supported board members to be elected.
There is nothing wrong with buying stock in a company because you like
the company. You'll get a copy of the annual report with some nice
pictures, and you'll get invited to the shareholder's meeting. But
for that, buying one share would be just as good as buying one
thousand.
Conclusions
I've argued that stock prices are largely set by shared conventions.
What lessons can we learn from this?
Is it a mistake to buy stock? No. History shows that stocks can
often be a good investment. You should just understand clearly what
you are getting into. You should look for stocks which pay a good
dividend yield, if you believe that the company will continue to pay
good dividends. Or you should look for companies which you believe
will be acquired for cash. Or you should look for companies which you
believe that other people will see value in.
Should you ignore P/E ratios and other such information? No. Since
you want to eventually sell your stock to other people, you should
think about the things which other people care about. However, there
is a clear shift in emphasis. Instead of thinking the low P/E
ratio means that this is a good buy,
think the low P/E
ratio is something which other people care about, and suggests that
they will think that this is a good buy when I want to sell.
Following this approach means that you have to pay attention to what
other investors are thinking about, so that you can shift your plans
accordingly. To be really successful in your investments, you should
try to anticipate what people will care about in the future.
What about technical analysis? Technical analysis essentially means
looking at past price movements to predict future price movements. If
everybody bought stocks more or less at random, that would be an
approach as good as any other. But people buy stocks because they
think they will go up in price for various reasons. You should pay
attention to those reasons, not to the way the price has changed in
the past. Actually, technical analysis is interesting in this sense:
if a lot of people use it, then you could use it too to predict what
they think about stock prices. Since I'm arguing that the goal of a
really successful investor is to predict what other people think will
happen to a stock, technical analysis might be a useful tool. I don't
really know how many people really use technical analysis, though.
Why do stock prices tend to go up over time? Actually, although the
U.S. stock market has historically gone up, it's worth nothing that
this is not true of all stock markets. Many stock markets have gone
down over time, or more or less stayed even, after correcting for
inflation. The U.S. stock market tends to go up because the
U.S. economy has historically expanded over time due to increasing
productivity, and because the U.S., with a historically stable
financial climate, attracts a great deal of foreign investment. The
overall effect is that, even after correcting for inflation, there is
more money in the stock market over time, which drives prices up on
average. And it's worth remembering that although the stock market
has consistently gone up over time, there have nevertheless been long
periods, lasting many years, where it has gone down before recovering.
If we are in one of those periods now, then most stocks would be a
good investment only for somebody both patient and young.
Do I have any hot stock tips? No. All my investments are handled by
my financial advisor.
Thanks
Thanks for comments from Jonathan Mark.