Does Valuing All of a Firm's Stock at the Market Price Badly Understate the Firm's Market Value?
By David Henderson
No, according to economist Jeffrey Rogers Hummel.
In a recent email discussion one economist claimed that we should be wary of measuring a firm’s value by multiplying the number of the firm’s shares by the price per share. His point is that the price of the firm’s shares on the market gives only the marginal value, the value that someone just barely willing to buy will pay. There are likely many shareholders, he argued, who value the firm’s shares they hold above the market price. What’s the evidence? Their behavior: they’re not selling. [I’m not quoting this economist’s name because I don’t have his permission.]
He makes a good point. But how much above the market price? Jeff Hummel argues that it’s not necessarily that much. I was thinking the same thing for the same reason Jeff gave, but he stated it much better than I had done in my mind. Here’s Jeff’s response:
I agree that the total subjective value of the stock of a particular good must exceed its price (marginal value) times quantity, as Warren points out. But the amount by which total value exceeds market value depends on the elasticity of the stock demand curve. In the case of housing, as Mark points out, there is probably a significant difference. But with respect to financial assets I think you push this point too far.We don’t have to go to the rational-expectations extreme of assuming that demand curves of financial assets are perfectly elastic to conclude that they are nonetheless probably quite elastic. After all, the primary reason that nearly all investors hold financial assets is because of their expected future returns. Financial assets are not like consumption goods, such as CDs, ice cream, or water, cases where some consumers subjectively value the goods way above their market price or where the first unit provides far more direct utility than the last unit. Thus I suspect the total value to investors of a company’s shares should not be significantly greater than the sum of the shares’ market value.I think Warren’s example of a hostile takeover actually illustrates my point. A takeover is attempted only when investors believe that new management can raise the present value of a corporation’s future earnings. These investors therefore must consider the shares to be properly priced under existing management. And even if there is significant variation in the subjective value of shares to shareholders, market value still gives the best available estimate of the present value of the shares’ future earnings.Which is why I also question the importance of Mark’s point about competing views of the future. That is not the only reason, nor even the most common reason, that investors choose one financial asset over another in their portfolios. Nor are the plans of different companies always incompatible. Indeed, much of the time their plans complement each other. True, in the future some companies will suffer losses, while others will earn pure profits. And one or the other will sometimes predominate. Financial assets seem to have been overpriced on net during the housing boom and then underpriced on net during the financial panic. But often, the errors in either direction should cancel each other out. So I think using market prices to estimate total financial wealth still provides a good approximation.