A longstanding question for Financial Analysts is whether or not stocks are fairly priced. What you may see this question as being phrased as, “Are markets efficient?”. The answer to this isn’t an easy one.
The stock market is a place where firms are listed and their shares are traded. Companies receive capital – shareholders can have ownership and participate in a company’s growth. Companies who wish to be listed have an initial public offering (IPO), an investment bank helps the firm understand how much the company is worth and therefore the price of selling the initial shares. After this has happened the shares trade freely on the secondary market, but a big question is: are the shares fairly priced? For example, today you can look and see that the share price of XYZ PLC is £100. But is it actually worth £100 or should it be worth more or less?
Cheap stocks, often called penny stocks are often thought to be the riskiest on the market, and therefore some would class these as undervalued versus more expensive stocks which may be correctly valued. Looking at the share price is therefore only useful when taking many other factors into account.
Technically, a stock is worth money because it is going to provide a stream of cashflows. Just like when someone buys a house and rents it out, this is valuable as someone is going to pay rent every month. If this rent is greater than the mortgage payment, then the owner of the house will make a profit, this is no different with businesses, they hope to bring in more in revenue than what goes out in costs, therefore a stream of future cash flows will make the valuable profitable.
However, in many circumstances, business is much more complicated than buying a house and renting it out, so the stream of future cash flows can be very uncertain, making the valuation of a company very difficult to estimate.
Let’s take UBER as an example, it’s a company that had explosive growth, it is disturbed a global industry, that hadn’t seen much change in many decades, BUT, it wasn’t making any money, it took until 2021, for Uber to report its first profitable quarter. This shows that it’s difficult to value the company, some investors may expect their future profits to be $1 billion a month, whilst others may be more or less optimistic.
Therefore, when we look at a company’s share price, it’s often hard to know whether it is over or undervalued.
What are the risks of buying an overvalued stock?
The way to think about this is by buying anything overpriced. If you bought a car that was overpriced, you may expect that eventually, it will make its way back to a fair market value, but the timing of this is key. This is the same with stocks, if you buy a stock for a $100 a share, and the fair market value is actually $80 a share, when you come to sell it we still won’t know whether the price will be above, below or at the fair market value.
So why do stocks go above their market value?
There are many reasons why a stock may differ from its market value, a lot of it has to do with sentiment. A great example is from a while ago but is still used to explain Market Efficiency to financial analysts today. A company had a new cancer drug that was expected to be revolutionary, the company was called EntreMed. The information was published on the front page of the New York times and the share price jumped from $12 to $52 per share. On the face of things, this may sound plausible, the innovation gave the company a more optimistic outlook and the chance of making additional profits in the future so it therefore should be worth more. However, the same information was published about the new cancer drug inside the newspaper weeks earlier, but crucially not on the first page.
Two things may have happened here, first, investors have so much information to digest, that they didn’t know about the cancer drug until it appeared on the first page. Or, perhaps more likely, there was an overreaction by investors and these investors drove the price away from its fair market value. In the long term, the share price fell significantly showing the fluctuations in price related to single stocks.