James Thurber wrote that “It’s better to know some of the questions than all of the answers.” The topic at hand helps prove the point.
Even though I’ve titled this post as a question, it’s probably more common to hear someone say flatly that a stock is only worth what someone will pay for it.
Are they wrong? Well . . . no. But also yes.
Do You Have to Sell or Not?
If you are compelled to sell right now, a stock is only worth the current quote.
That’s not a good position to be in. That’s why we advise our clients to keep a cash reserve for expenses that are reasonably foreseeable.
At other times, it’s up to you to decide whether to take advantage of prices that are being bid.
How Are Prices Determined?
When some people say that a stock is only worth what someone will pay for it, they really mean that prices are determined by luck. What sells for $100 today could trade for $10 tomorrow. Successful investors, they think, are no better than winners of the lottery. Luck is the key thing.
But even though prices can be crazy, it’s worth applying some rational thought to the subject. You don’t have to accept what’s being offered. Eric often illustrates this point by asking whether a client would feel compelled to sell their expensive house for $30,000 simply because someone knocked on the door and made that offer. Of course not.
Time to Hit the Books
The finance textbooks say that a business is worth the value of the income it can produce over time, adjusted for the timing and certainty of receiving those returns. Stocks are ownership interests in businesses. When news comes out, it’s examined for the impact it may have on the estimates that go into valuations.
This isn’t to say that each investor in the market is aware of the precise impact that news will have or that they rush to update a detailed valuation spreadsheet.
But the market as a whole does make adjustments as the outlook changes. A slowdown in the economy may reduce the income a company is expected to produce. If the company is poorly funded, it may not make it.
The Current Uncertainty
In times of particular stress, as now with the coronavirus outbreak, there can be a general increase in uncertainty.
It’s plain how some companies are being affected. Those in the travel industry are hurt directly as people cancel trips. But there are less obvious impacts in a complex economic system.
For instance, worried investors may decide not to provide as much funding to startup companies. That would reduce demand for office space, hurt real estate developers, and lead to higher losses for banks. Banks, in turn, might become more reluctant to lend.
But in a flexible economic system that welcomes investment, there will be adjustments that help set the stage for an upswing. Investors will come to expect better earnings and less uncertainty. Estimate changes will become positive for valuations.
Stocks will be worth what someone is willing to pay, yes, but a potential seller may find that prices then coincide with his estimate of long-term business value. Not having been compelled to sell when prices were low, he can realize a better price.
Barry Dunaway, CFA®
America First Investment Advisors, LLC
This post expresses the views of the author as of the date of publication. America First Investment Advisors has no obligation to update the information in it. Be aware that past performance is no indication of future performance, and that wherever there is the potential for profit there is also the possibility of loss.