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Stock Price Formation From A Value Standpoint

Although ardent value investors are typically not overly concerned with stock price, once an equity

stake in a desirable target has already been purchased that is. We are as a group, intimately interested in the initial price we pay for our share in a prosperous enterprise.

With that in mind, this article will attempt to accurately convey some of the basic precepts of both the quantitative and psychological aspects of price formation on today's stock markets and offer some general guidelines on how to profit from such movements.


Quantitative Aspects

The fluctuations of share prices are essentially due to two primary causes:


  1. The fluctuations in dividends and net earnings

  2. The fluctuations in the rate of interest at which the fluctuating dividends are capitalized.

With that said, The correlation of stock market movements and changes in business activity (earnings) has become less close in the past century than it used to be. According to some writers such a correlation no longer exists at all, but rather that stock prices in the long term are dictated almost solely by the fluctuations of the various rates of interest which are centrally planned.


Therefore, we should be focusing our attention primarily on the prevailing interest rates and how they correlate with the earnings and dividends generated by our individual equity holdings. As the stock market over time will price an individual company's shares at a price that reflects the value of its earnings relative to the yield offered by long-term corporate bonds.

Of course, as most people have experienced stock market swings can be very volatile from the depths of a bear market to the wild optimism of raging bull markets, but over time it is long term interest rates that determine the economic reality of what long term investments are worth.


Qualitative Aspects

Although from a purely qualitative standpoint most people tend to regard stock prices to be the result of general opinion, in reality they are the result of the general opinion on what the general opinion is going to be.

From this point of view all stock market transactions are thus based on probability judgments. If this is to be believed, in order for one to operate successfully in the market today he must:

Firstly, be highly informed

Secondly, have the ability to drown out mass opinion so as to be able to buy when the majority is deeply pessimistic and to sell when the majority indulges in exuberant optimism. While at the same time not underrating the power of mass opinion so that one neither sells to early before mass optimism ends, nor buy to early before mass pessimism has run its full course.

Experienced market operators always lament the above stated, that is success depends largely on the ability to go against the prevailing tendency, i.e. against mass opinion, at the very moment when its correctness is least in doubt. The difficulty in practice is, of course, to know exactly when the forces of mass opinion run out at the end of every exaggeration phase and vice versa.

The truth is that forecasting future markets will always remain a highly subjective art and never an exact science and anyone claiming differently in that they can scientifically call the length or end of bull and bear markets respectively are either knowingly or unknowingly disillusioned.

With the above stated, one will generally do better by simply analyzing the individual company they are interested in taking a position in from both a qualitative and quantitative standpoint and doing their best to be aware of the mass delusions of speculators and stay away from them altogether.

Sources: Common Sense Economics By L. Albert Hahn | Warren Buffett & The Interpretation of Financial

Statements Pg. 161-165 

Disclosure: No positions