Priceless: The Myth of Fair Value (and How to Take Advantage of It) [Bargain Price] Chapter 51 is called The Mischievous Mr. Market:
"Late at night, you're flipping channels and see an infomercial for an amazing new product. It's a little black box that, exactly once a year spews out a crisp new dollar bill. It's perfectly legal, the pitchman assures you, and you can spend the dollar any way you want. The box will produce a dollar this year, next year, the year after that, and so on-forever! How much would you pay for a product like that?
|Magic money printer|
One way of evaluating the box's worth is to imagine how you could spend a dollar a year. You could tip someone you don't like at Christmas....supersize one fast-food order next summer...You will probably conclude that the box is worth paying at least a dollar for. You'll recoup that the first year, and then afterward it will all be gravy.
You might also reason that the box is worth less than your current life expectancy in dollars, since that limits how many dollar bills you can collect. (For the record, the box keeps working after the original owner's death, and you are allowed to bequeath it to anyone you like.)
Your price for the box should have something to do with your capacity for delayed gratification. That is, you're giving up some of your hard-earned money now, in the form of purchase price, to enjoy a stream a stream of earnings later. Someone who is focused on the present- the guy who's always maxing out his credit cards- might not be interested in the box at all. Someone who looks at the long term might be willing to buy a relatively high price.
One thing is clear. There is no indisputable right price. Should the infomercial's studio audience clamor to buy the box for $2, most viewers would probably accept that as a reasonable price. Should the crowd decide it's worth $60, that would be reasonable too.
Benjamin Graham, the legendary founder of value investing, had a simple answer for the value of a $1-a-year black box: $8.50. Graham was actually speaking of stocks. A share of stock produces a stream of future earnings. Divide the share price by future earnings per share, and you have the price-to-earnings ratio. It tells how much buyers are paying for a dollar of future income. Since the black box produces an income of $1 a year, the price you pay for it, in dollars would equal its P/E ratio. In Graham's analysis, the stock of a company with no earnings growth should sell at a price-to-earnings ratio 8.5.
Graham caricatured the price psychology of investors in "Mr. Market." He's a well-meaning doofus who shows up at your door every weekday offering to buy or sell a stock. Every day, Mr. Market's price is different. Though Mr. Market is persistent you don't have to worry about offending him. Whether you accept his offer or not, Mr. Market is sure to be back tomorrow with a new price.
According to Graham, Mr. Market really doesn't know what stocks are worth. The smart investor can profit from this. One day Mr. Market will offer to buy your stock for more than it's worth. You should sell! Another day, Mr. Market will offer stock for less than it's worth. You should buy!
It worked for Graham and for a few of his disciples, like Warren Buffett. Following Graham's advice is easier said than done. During the bull markets, less kindly known as bubbles, Mr. Market shows up every day quoting sky-high prices that only seem to go up. Most investors find it impossible to ignore the siren song. How could Mr. Market be so very wrong, day after day?
As early as 1982, Stanford economist Kenneth Arrow identified Tversky and Kahneman's work as a plausible explanation for stock market bubbles. Lawrence Summers took up this theme in a 1986 paper, "Does the Stock Market Rationally Reflect Fundamental Values?" Summers (now head of the National Economic Council for the Obama Administration) was the first to make an extended case for what might now be called the coherent arbitrariness of stock prices. From day to day the market reacts promptly to the latest economic news. The resulting "random walk" of prices has been cited as proof that the market knows true values. Because stock prices already reflect everything known about a company's future earnings, only the unpredictable stream of financial news, good and bad, can change prices.
Summers astutely pointed out that this 'proof' doesn't hold water. The random walk is a prediction of the efficient market model, just as missing your train is a prediction of the Friday-the-13th-is-unlucky theory. You can't prove anything from that, as there could be other causes producing the same effect. Summers sketched one, a model in which stock prices have a strong arbitrary component yet adjust coherently to the day's financial news.
Summer's idea is a scary one. It proposes that stock prices could be a collective hallucination. Once investors stop believing, it all comes tumbling down. In the past century , the S&P's P/E ratio has varied from less than 5 (in 1920) to over 44 (in 1999). Some of that variation is reasonable, but Graham believed that most investors make emotional decisions to plunge into or out of the market and didn't care much about the price.
The misfortune of the market is that memories are short and too much time elapses between bubbles. The investing public has a whole never has the opportunity to make decisions, see their consequences, and change their behavior accordingly. There is no Groundhog Day, and thus investors are condemned to repeat Black Monday.