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What is the true worth of a company? This is both a very difficult question and an easy one – depending on how you look at it. Consider the idiom “how long is a piece of string?” This is often used in reply to a question that is difficult to quantify, and is a near perfect analogy for this discussion.
It too can be difficult to answer or very easy. Although it can seem a little facetious, one could quite accurately respond by saying that the length of a piece of string is simply the distance between the two ends.
So it is with the question, “what is the true worth of a company?” While analysts can employ complicated models and calculations in order to ascribe a fair or intrinsic value, the best (and most accurate) answer is in fact very simple. The true worth of a company is exactly what the market says it is!
The online auctioning process that determines share prices is an extremely efficient one, and will ensure that essentially all available information is accounted for in a fairly accurate way over time. But this doesn’t mean that there won’t often be perturbations that traders can take advantage of.
Whether a share price goes up or down depends on who is more eager to execute a trade; buyers or sellers. When sentiment is high and the outlook is positive, buyers will be more inclined to raise their bids, whereas sellers will be more reluctant to sell. As a result, the share price will inevitably move up. On a day where everyone is panicking and pessimism abounds, it will be buyers who have the upper hand and sellers will quickly drop their offers in an effort to off load their stock. Of course in this situation prices will fall.
Understanding this we can appreciate how it is that share prices fluctuate in the short term. It’s not necessarily the case that anything fundamental has changed, it’s just the result of the interaction between large numbers of investors each of which has their own opinion on the true value (which may or may not be entirely rational).
Traders who have taken the time to identify sound businesses can take advantage of market panic and buy into stocks that are being unfairly sold off. Likewise, if stocks have rallied with little or no justification, traders can look to take advantage of the downside.
Given the current climate of fear and uncertainty it is little wonder that we are seeing so much volatility. The important thing to remember is that behind all of this there remains many sound businesses that, although likely to experience erratic and unpredictable changes in value in the short term, will eventually be recognised for their inherent worth. This in turn will lead to an increase in demand, which will in turn lead to increasing prices. So in many ways, a market recovery is mostly dependant on the return of investor confidence.
Make the markets work for you
Andrew Page
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