Economies globally have been facing significant challenges due to COVID-19 with the pandemic causing the largest global recession in history. According to certain estimates, the virus could trim global economic growth between 3% and 6% in 2020, with a partial recovery expected in 2021, assuming no second wave of infections. Despite the negative news and bleak current economic data and forecasts, the equity index of most major markets has reached record highs over the recent period. This begs the question: How and why does the share market continue to reach record highs, specially, if investors generally expect economic growth to be a key driver of the markets?
The answer lies in what we call a difference in the market price and intrinsic value of a stock.
What is Intrinsic Value: Intrinsic value refers to the real worth of the stock determined through fundamental analysis without reference to its market value. It is a subjective value that varies from one analyst to the next. In an intrinsic valuation, a stock is valued based upon its intrinsic characteristics that attaches to the asset, based upon its fundamentals: cash flows, expected growth, and risk. Many valuation models have been prescribed for estimation of intrinsic values, but the most suitable of all is a matter of debate in the finance community. Company or business valuation continues to be a matter of debate.
What is Market Price: Market price per share is the most recent price that a stock has traded for. It is a function of market forces, occurring when the price a buyer is willing to pay for a stock meets the price a seller is willing to accept for a stock.
Should Intrinsic Value and Market Price be the same?
According to a financial economics theory known as ‘efficient market’ theory, share prices reflect all information and stocks always trade at their fair value on exchanges. Many studies have examined the relationship between the intrinsic value of companies and the market prices of their shares. However, there are different schools of thought on the relationship between intrinsic value and market prices. On one hand Warren Buffett, one of the most successful investors in history believes that the intrinsic value differs from the market price, whilst on the other, Professor Eugene Fama, a distinguished finance academic, argues that the prices of stocks reflect their fair values. However, neither of these successful individuals dismiss the other’s views on markets entirely.
Generally, the ‘efficient market’ theory has largely been discredited as impractical. The belief is that humans do not always make rational decisions, do not always pay reasonable prices for assets, and markets are not always reflective of economic reality for a variety of reasons. This raises doubts on the efficiency of the market or maybe a new dimension in the model of intrinsic value is required which can bring intrinsic value closer to its market value. Intrinsic value fails to explain the change in market price which further indicates the existence of irrational expectation of investors in the market. This further widens the gap between intrinsic and market price.
There is no clear answer as to whether the intrinsic value and market value should be the same at a given point in time. On one hand, there is no unique method of intrinsic value determination to suit all circumstances. Its determination is both an art and a science. The inputs are based on judgement and the process is far more subjective. It is an estimate of a stock’s “true” value based on available risk and returns data. It can be estimated, but difficult to measure precisely. On the other hand, a stock’s market price is based on perceived but possibly incorrect information.
In a scenario where the intrinsic model captures all available fundamental information of a company to a great extent, the price and value of the company are believed to converge in the long-term but may diverge in the short to medium term. As Benjamin Graham points out, in the short term, the stock market behaves like a voting machine, but in the long term, it acts like a weighing machine – with its true value being reflected in the long run.
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