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What Determines Value?

October 21, 2014

Last week, the stock market took a tumble. Not pretty! What happened to cause so much loss of value?

News happened. Some of it was shocking, scary and upsetting. On January 28, 2014, I posted a blog entitled, The Market Tanked Last Week – Does it Matter? I suggest you re-read it. Today, I want to take a different approach and discuss what determines value for stocks.

Many things determine value on a short-term or temporary basis for stocks, but I submit that sustainable earnings growth determines value for the long haul. With some weird exceptions, the expectation of a payout either in the form of growing dividends and/or stock growth will determine the value. Temporarily, anything can happen and values can and do fluctuate widely, but on a long-term basis it is sustainable earnings growth. For investment purposes, I consider periods under seven years as “temporary.”

Steady and measured dividend growth is a good way to assess valuation. So does the expectation that the shares can be sold at a later date at a profit. Analysts and economists contend that the price of a stock is the present value of expected dividends plus the growth in the value of the stock. Statistically, periods longer than a dozen years do not have much weight in the present value calculations. Dividend and stock price growth over about the next 10 or 12 years are what should be looked at when assessing current stock prices. Differences in thinking and evaluating data cause people to buy or sell creating trading activity. There are also traders, not investors, looking for temporary inequities that go in and out as they see it creating some sort of balance to the current stock pricing.

An exception is Warren Buffett’s Berkshire Hathaway (BRK) that does not pay dividends. Mr. Buffett believes he can invest the money at much greater returns than his stockholders, so BRK keeps growing and growing and growing. There is also a self-created floor on the value with Buffett’s stated indication that BRK will buy back shares if the price drops below 120% of book value. However, a return on investment from BRK can only be realized when the stock is sold.

Besides traders and company performance, there are many outside factors affecting valuations on a short-term basis such as price to earnings ratios, interest rates and yields, meeting or missing earnings’ expectations, the overall level of the stock market, volatility of trading, prices of raw materials, currency exchange rates, availability of suitable labor, company and economy growth expectations, tax rates and policy, profit margins, competition, and continued viability of the company and its products – current and new ones in the pipeline, its management and its role in the overall marketplace, to illustrate just a few value drivers.

The issue is that investors generally do not always agree. Valuing stock too high has you giving up growth for a period of years. Too low can provide you with an opportunity to make an extra buck. There have been protracted periods when the overall market or sectors were simply valued too high, and we know the effects of this [The NASQAQ is still lower than its high of 5408 on March 2000]. But over the long-term, the current price needs to provide a reasonable dividend that will grow and a reasonable stock valuation that will also grow. Not tomorrow, or a year from now, or even five years from now, but over a long-term because at the end of the day – most of us invest to assure our long-term financial security. That is what needs to determine the value of what we buy today.

3 Comments leave one →
  1. 6hawthorne permalink
    October 21, 2014 4:51 pm

    hi ed this was a good article enjoyed reading itBob Nagler

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