Stock Price as the Basic Indicator
Most investors will agree that the stock's current market price per share is a basic indicator. For most of us, price is the first impression we have of a stock. The stock market is an auction marketplace because buyers and sellers cause stock prices to move based on their own perceptions of value and the price they are willing to pay. A greater number of buyers, all bidding on a relatively limited number of shares for sale, drive up the per-share price. A greater number of sellers, all seeking a relatively limited number of willing buyers, drive down the per-share price.
KEY POINT
Supply and demand for shares of stock is what sets that stock's price. While fundamentals have a long-term effect, day-to-day price movements reflect only the immediate perception of value.
Market price works as a basic indicator even for the fundamental analyst. We know that market price is an immediate measurement of the market's perception of value. It may have nothing to do with fundamentals, at least directly. However, if a particular company's stock is chronically below the level where it should be, there usually is a reason. That reason may be found in the fundamentals.
Example: In one industry, stock prices generally fall within a specified range in comparison to earnings, (also called the PE ratio,or price-earnings ratio—more on this later in the chapter). One stock, however, trades at a very low PE when compared to others. You wonder why.
It is wise to wonder why a PE ratio for one company would be exceptionally low (or exceptionally high) compared to the industry average. As an investor, you expect an investment candidate to fit the model as dictated by tests that you depend on for information. You may be sure that the answer to exceptionally low PE ratios will be found in the fundamentals, because the market perception about a company's value does not occur in a vacuum. This is why the price and the PE ratio are important tests. Some investors believe that it is possible to find exceptional values that everyone else has missed. In fact, some short-term only buying opportunities can be found. The market tends to adjust pricing of stocks based on the fundamentals, the most important of which is earnings. This is why the PE ratio is one of the most popular and important tests used by investors. It shows how the market views a particular stock based on earnings.
KEY POINT
You are wise to question why a particular stock's PE ratio is exceptionally low or exceptionally high. Invariably there is a reason, and that reason is important information for you as an investor.
Stock price also should be compared to book value per share. While this is not commonly used as an indicator for purposes of forecasting future value like the PE ratio does, book value per share remains an important fundamental test. If market value per share is vastly higher than book value, you might wonder why the market has such high esteem for the stock. There may be good reason, or it may indicate a corresponding exaggeration in the PE ratio. Wide disparity between stock price and book value per share can be a danger signal. Likewise, what does it mean if market price is very close to book value per share, or even lower? This indicates very little market interest in future prospects for that stock. It could mean there exists a real opportunity; it is more likely that market perception is dependable and should not be ignored.
Why is the difference between market price of stock and book value per share so interesting? Investors do not pay much attention to book value per share. Chances are good that most investors would not be able to even tell you the book value of their stock if asked, whereas many would know the PE ratio. But the comparison is important—because even though the fundamentals are the key to smart long-term investing, accounting is an imperfect art. The methods used for reporting a company's worth and profits are far from perfect.
KEY POINT
Market perception reflects future potential, which may be more reliable than the more rigid conventions of financial reporting.
Accounting rules are conservative. For example, a company might own vast land holdings for many years, but the true market value of that land must be reported in the books at original cost. So you cannot tell from studying the balance sheet what a company's real net worth per share would be if the company were to be liquidated. Book value per share reflects the conservative reporting required under accounting rules. It does not reflect what the market perceives or knows about that company's growth prospects, the real value of its assets, or its potential to out-compete other companies in its industry.
In the 1970s and 1980s when takeovers defined large segments of the market, these problems became glaringly obvious. Some companies were taken over primarily because someone recognized that the real value of the company's assets was greater than the market value and certainly greater than book value per share. It was possible to acquire a controlling interest in a corporation and sell off its parts— land, subsidiaries, inventory—and make a profit greater than the acquisition cost.
