This memo is about what is the reasonable mental procedure to calculate correct stock price of one share of the company taking into consideration dividends, bank interest rate and general market trends.Obviously nobody can predict a price of anything with 100% accuracy. For truth sake prices are not predictable even with 51% of trustworthy. Future is unpredictable in principle. It can be manipulated but not foreseen. This memo is about what is the reasonable mental procedure to calculate correct stock price of one share of the company.
The formula for sane stock price is:
P = kr*d/I + (1- kr)* P-*(1+ΔP/P-)
where: P - price of share, d - projected dividend per one share; I - best bank interest you can get (not in a form of percent but in parts; 3% interest rate here = 0.03) ; P- - price of share year ago; ΔP - average change price per year; kr - coefficient of sanity (level of skepticism or nonconformism) of the person who estimates a price of share.
Let's do some explanation of the formula. Presume that some company has more or less stable stock prices without obvious neither positive nor negative trend. In this case one person should expect that if he put his money into bank and then take them in one year with interest he would get the same result as if he buys a share of this company and then in one year sell them for the same price and in addition will collect a dividend.
This is a fundamental concept of free market that does self adjusts on the long run to the situation when all investment options have bring the same profit. because market is free and transparent. If there is better opportunity investor is free to withdraw his fund and reinvest. If there is some option that looks like not attractive but it is exists anyway it means something is hidden.
In this case of stable (stagnant) market the right price of the company stock is Pd=d/I, that is mathematical condition for equality of profit received from dividend or from bank account with interest I. The larger dividend the larger price that is obvious. The smaller bank interest the larger price of the company. It is not the same obvious but apparent nevertheless. Investor has to put his money somewhere - if bank does not pay practically anything - option to get dividends became attractive.
In case of trendy market one can believe that the tendency will continue
long enough to secure sell. In the history stock market had indeed
long periods when such kind of presumptions happened to be correct.
In this case a price of one share will be equal Pt
= P-*(1+ΔP/P-) - just extrapolation
of existing trend that in simple words means presumption of the
same change of share as it was in previous year.
Coefficient kr - is a physiological characteristic of the person making decision. Some people tend to be more conforming then others and rely omore on price trending than on hard calculation of guarantee(?) dividends. Let me note that there is no such thing as guarantee in this dangerous word but most of us reasonable put not null possibility of asteroid strike aside when decide about finances. It is reasonable because there is no point care about financial situation if everything in ruins. So kr - is the measure of average market participant optimism.
So only in very stagnant marker a dividend bases price could find common agreement; in all other situations there will be distribution of opinions about real price. And investors will trade with each other moving price around "correct" level. The longer a positive or negative price tendency exists the more it is self-supported. Other way around the longer there is continuation of existing trend the larger possibility of its inverse.
Most interesting points for discussion sake is a moment of breaking
of long established trend like it was in 2000. The exponential growth
of DOW about 20 years practically took out off minds of investors any
thoughts about influence of dividends on price. But prices cannot grow
eternally long. The natural limit is a money volume able to be
used for speculations.Magic of number 10000 played its role in
the setting a roof for expansion too.
Break of trend establishes self accelerating trend of different direction.
The only possibility for regulators to avoid non-controlled crush even below level of dividend determent prices were changing banking interest. That was done.
It was diminished almost to zero that effectively increase Pd times more compare to actual.
But this regulative option is exhausted to 2004. Bank percent will be increasing that leave us only too options - dramatic fall of DOW or strong inflation. Looks like that it will be both but not great but just big.
First submitted at Nov. 21, 2004; 16:17
The text above was published in 2004 practically in the same form. There were only small changes in style.
Since that time there were a lot of events to evaluate these apparently confirm main idea of the article. The price of the stock market depends on two major factors - real performance of the companies expressed in the level of dividends and financial environment regulated by government, FED that set interest rate. Of course government regulation cannot be unrelated to real economy, actually they are aimed exactly to improve these conditions but any artificial influence makes market not pure free.
In any way because many factors these include computerization, demographic factors, limitations of our planet abilities in size and absorption of humanity waste the economy cannot be sustain by itself without financial tricks. Since crisis of 2008 when normalization of bank interest practically crushed all other investment opportunities there is great money printing and close to zero interest rate. It moves stock price artificially so high that there is practically no more point to speak about correct price.
After 2008 we know what will be. Crash and bailout. Or something so catastrophic that no need to scare anyone - nobody will stay to be scared.
There is one more possibility. Artificial way on the edge of razor to completely other social system. It is easy to predict when- the condition is when labor rate participation will be stable less than 50%. At that point jobless people will be majority and take political power. Projection of present trend gives about 30 years till this point. If trend will be linear that doubtful because of startling progress in artificial intellect.
Nov. 15, 2017; 11:43 EST