The price of a stock is established at the point where the most eager buyer meets the most eager seller. Once they’ve cleared their order books, the market waits for the next pair of eager traders to agree on a sale.

15x earnings is reasonable, but the market is often anything but reasonable

If you want to sell your shares, you need to place the best (lowest) offer for sale in the market and wait for an eager buyer to accept the price you demand. Alternatively, you can “hit the bid”, i.e., sell at the price offered by the best buyer (i.e., the highest bidder in the market).

The market capitalization of a company is calculated by multiplying the market price by the total number of shares. In practice, that’s pure fiction; it’s impossible to buy or sell the entire company in the market at that price. However, for smaller amounts of shares, considering the market price as the price for the entire company still makes sense since it’s associated with the profits and cash flows calculated on a per-share basis.

It is rational to pay a price that gets you a decent return on your investment. Your return is the sum of your future dividends and the price you get when selling the shares to somebody else. The same rational calculation applies to the next buyer, and so on.

Historically, it is sensible to pay around fifteen times next year’s normalized earnings per share for an average company. Ex-post, this has resulted in a 10% annual return for stockholders.

On average, investors are ready to pay 15 times earnings, indicating their satisfaction  with a 10% annual return. This trend has persisted for the past century. Perhaps you personally consider it  insufficient (or excessive) compensation, but that’s just how it is. Valuations have been higher during boom times and when borrowing costs have been cheap, and lower during pessimistic times..

Who determines the price of a stock in practice?

Who are the buyers and sellers, and what influences their decision making?

Index funds

The largest and most important group of buyers in the 2020s are probably index funds. These funds have to hold stocks in specific proportions to their assets under management. When they receive a billion dollars inflows, they evenly allocate that money among the constituent stocks in the index they aim to replicate. This obliges them to buy shares in companies like Apple, Amazon, Microsoft and so on. Or sell if they get outflows. Further, they adjust their holdings based on the relative price performance to maintain portfolio weights that mirror the index they track.

Index funds are valuation blind. They couldn’t care less whether a company is valued at 1000 times earnings or 2 times earnings, or  the company is loss-making, fraudulent, growing or shrinking. They only care about the company’s weight in the index. More than half of all money invested on the stock markets are held in index funds.

Algo funds, in particular momentum funds

Many funds use a systematic pattern-based approach to investing. They identify the direction in which  stocks are trending and buy those on the rise while selling those on the decline. There are more nuances, but in practice, most of these funds are momentum players/trend followers . Some may follow mean reversion strategies, hoping for soaring stocks to return to more established levels again. Most of these funds are also valuation blind (agnostic). They just buy and sell based on  identifiable patterns, often exaggerating recent price movements.

Index funds and algo funds together have the potential to push a stock to unwarranted highs, since they don’t care about the actual valuation. They mostly focus on owning the right amount of stocks that are moving.

Other interest groups include hedge funds, actively managed valuation-based funds, investment companies, value investors, activist short sellers, macro-based funds (sometimes absolute value, sometimes relative rotation), and private individuals.

Incremental flows govern market prices, not thoughtful valuation

An important dimension of the interaction between sellers and buyers is whether their decisions are mainly governed by absolute factors or incremental factors. This applies to both valuation-based investors and value blind investors.

The market is influenced by incremental rumors, news flow, large (whale) value investors, activist short sellers, macro investors, macro analyst reports, and peer valuations. Absolute vs relative, incremental vs absolute level. Incremental flows govern markets. A vote. Not a scale weighing fundamentals.

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