Theory of Stock Prices

Theory of Stock Prices

The Firm-Foundation

The greatest of all gifts is the power to estimate things at their true worth (La Rochefoucauld, Reflexions; ou sentences et maximes morales).

Investors can and and should learn vicariously from the stock market in order to save them from the traps that ensnare builders of castles in the air. Autopsies should be as useful in the practice of investment as in medicine. At the same time, to be forewarned is not to be forarmed in the investment world. Investors also need a sense of justification for market prices – a standard, even if only a very loose one, with which to compare current market prices. Is there such a thing? We happen to think so – though I believe it neither rests on a firm foundation nor floats like a castle in the air.

The firm-foundation theorists, who include many of Wall Street’s most prosperous and highly paid security analysts, know full well that purely psychic support for market valuations has proved a most undependable pillar, and skyrocketing markets have invariably succumbed to the financial laws of gravity. Therefore, many security analysts devote their energies to estimating a stock’s firm foundation of value. Let’s see what lies behind such estimates.

The Fundamental Determinants of Stock Prices

What is it that determines the real or intrinsic value of a share? What are the so-called fundamental that security analysts look at in estimating a security’s firm foundation of value.

Theory of Stock Prices. Photo by Elena.

Firm-foundation theorists view the worth of any share as the present value of all dollar benefits the investor expects to receive from it. Remember that the word “present” indicates that a distinction must be made between dollars expected immediately and those anticipated later on, which must be “discounted.” All future income is worth less than money in hand; for if you had the money now you could be earning interest on it. In a very real sense, time is money.

In arriving at their value estimates, firm-foundation theorists usually take the standpoint of a very long-term investor who buys his shares “for keeps”. The only benefits such an investor receives will come to him if the company pays out some part of its earnings in cash dividends. Thus the worth of a share to a long-term investor will be the present or discounted value of all the future dividends the firm is expected to pay.

Of course, the price of a common stock is dependent on a number of factors. We will now describe four determinants affecting the value of shares and then give four broad rules for applying these to determine the present (or firm-foundation) value of the stocks you are considering. If you follow these rules consistently, firm-foundation theorists suggest you will find yourself safe from the speculative crazes.