Why Stock Prices Can and Do (and actually should) Gyrate Rather Wildly

When the stock market declines by 10% or 20% or more in a short time period it is often claimed that there is no way that any change in fundamentals could have justified such a rapid change in valuation.

Actually, let’s look at the math:

Fundamentally, a stock’s intrinsic or true value is the present value of the cash that it can be expected to throw off to its owner(s) over its total future life (between now and doomsday).

To illustrate the valuation math we can use a hypothetical idealised case.

Consider a hypothetical stock (share) that currently pays a cash dividend of \$1.00 and where that dividend is expected to grow in perpetuity at 4% per year as the company’s expected earnings per share also rise in perpetuity at 4% per year. At any given time there is a market expected or required return for an investment with a similar level of risk, for example 8%. This is the “competitive” return for an investment of a given level of perceived risk and it is set in the market and it varies over time. Cash to be received in the future is not as valuable as cash in hand today and must be “discounted” by the market required return level associated with the perceived risk, in this case 8%.

The theoretical value of this hypothetical stock is given by the formula: Value equals the initial dividend divided by (the required return rate minus the growth rate).

In the example above, the theoretical value of this share is \$1.00/(0.08-0.04) = \$1.00/0.04 = \$25.00. In this case the share is worth \$25.00 and the dividend yield, at that price, is 4%.

But what happens if the outlook for the company improves and analysts speak and write enthusiastically about the company and the expected growth rises to 6%? Now the theoretical value changes to \$1.00/(.08-.06) = \$1.00/.02 = \$50.00 and the dividend yield, if the price rises to \$50, is 2%.

Here the growth rate rose 2%, which may not seem like that much but is a 50% increase in the growth rate, and the theoretical value of the stock increased by 100%!

It is certainly not beyond the realm of possibility that the expected growth rate of a company could quickly change by 2% and cause this 100% increase in the theoretical intrinsic value of this stock.

For the stock market as a whole it would certainly be possible for the expected GDP growth rate (and/or the earnings growth rate of the average company) to change by 1%. If we assume that the theoretical stock above with an intrinsic value of \$25 represents an average company then this change in the growth rate of just 1% could increase the value of the average company and therefore the entire stock market by 33% since \$1.00/0.03 equals \$33.33 or decrease it by 20% since \$1.00/0.05 equals \$20.

This math demonstrates that the value of a stock or even the entire stock market can legitimately change fairly dramatically and quickly if there is even a modest change in the expected growth rate.

Similarly, the competitive market level of the required return on an investment can change due to changes in interest rates or due to changes in the appetite for risk among investors or changes in the perception of the risk level of a particular company.

If the required return in the example above declined to 7% then at 4% growth the value changes to \$1.00/(0.07-0.04) = \$1.00/0.03 or \$33.33 for a 33% increase in value.

When you consider how very sensitive the theoretical valuation is to the required return (which is related to interest rates, perceived risk levels, risk appetites and competing investments) and to the expected growth rate, both of which can change significantly and rapidly, then the wonder is perhaps not so much that stock markets sometimes change by 20% or more in a short time period, and that individual stocks can sometimes change by 50% in a day, but that it does not happen faster and more frequently.

The notion that fundamental values cannot change extremely rapidly is simply not correct.

To the extent that estimates of growth rates and estimates of the competitive level of returns change rapidly (and they do) then the fundamental value of individual stocks and the stock market as a whole do change rapidly and therefore stock prices should change and gyrate fairly wildly in response (and, in fact, they do).

I often hear in the news that Canada needs to attract more foreign investment. Often there are calls for the government to seek out such investments and also to insure that Canada has policies and regulations that are receptive to investment. The assumption seems to be that more foreign investment is always a good thing. But I am not convinced of this. I think the need for foreign investment depends on the type of investment and whether or not the economy “needs” that investment and whether or not there is a shortage of domestic investment money.

I would agree that government policies including taxation levels, royalty rates on crown resources and various regulations should not discourage either domestic or foreign investment. However each Country (and Province) is entitled to set reasonable levels of taxation, royalties and regulations for both domestic and foreign companies. Even where investment is desired, it is seldom to be desired at all cost.

Also, when it comes to infrastructure investments, governments need to insure that regulatory approvals can be obtained in a reasonable time frame and that opponents to development cannot unjustly hold up those projects that should be approved. There is no point attempting to attract investment if it is the approval process that is the barrier to development.

Once a government has set reasonable policies that are appropriately receptive to investment by both domestic and foreign firms then I am not sure that it is the role of government to actively encourage, much less subsidise, foreign investment. By experience, the world has learned that the free market does a very good job of attracting private investments in profitable undertakings. Few of us would argue that government actions are needed in order to attract investments in such things as, for example, retail stores, entertainment services, housing, office buildings, banks, utilities or communications systems. The central planning of the quantity of investments in these businesses has not had a general history of success.

Undue competition with existing businesses is also a concern. If a government attempts to attract private investments into any for-profit enterprise it may be rare indeed that there is not some existing domestic private business that would be harmed by the new competition. And it would probably never be the case that there is not some private company somewhere in the world that would not be harmed by any government-assisted competition though that may not be a matter of any concern to the government. Competition is a good thing, but having the government encourage or certainly subsidise competition against existing businesses may not be a good thing.

There are also several different types of foreign investment.

A physical type investment would be one where a foreign company comes in and spends money to create new assets in Canada. This could be tangible assets such as buildings, transportation systems, communication systems, mines, factories, refineries etc. as well as non-tangible assets like software. This could certainly be beneficial if it is providing goods and services that would not otherwise be produced in Canada and where it is not unduly competing with existing Canadian businesses and where the investment would not have occurred without foreign investment.

A monetary investment would be where a domestic company obtained debt (loans) or equity investments from foreign investors. This could be beneficial if there is a shortage of domestic investors. While such foreign investment should not be discouraged, it’s not clear to me what role government would have in encouraging it to take place.

A transfer of ownership type investment would be where a foreign company purchases existing assets and businesses from a Canadian holder. While this would free up cash for the former owner, this is not a true physical investment. To the extent that foreign investment is desired for the economy, I would view this transfer of ownership type investment to be far less desirable than a true physical investment that created new assets and new businesses in the country.

The following are some thoughts on the types of private sector foreign investment that Canada could attempt to attract:

Investments in new oil and gas development: At the present time, Canada and certainly Alberta appears to have already over-invested in this area. A world-wide glut of supply has pushed prices down to unprofitable levels. Encouraging more production would provide a short-term boost as the project is constructed but ultimately would harm existing players in the market. The same comments would seem to apply at this time to attracting investments in the production of most other commodities including metals and minerals and potash.

Investments in refineries and petrochemical plants to upgrade raw resources: It is often said that Canada could benefit from such investments. And if there are profitable opportunities for such upgraders that are not being funded domestically then attracting foreign investment would seem to be good thing. However, the actual barriers to the construction of such plants may be far more related to the ability to compete against existing foreign plants, the difficulty of obtaining approvals to construct in the face of opposition, and the lack of pipelines (for liquids) to bring the product to market especially if it is to exported.

Investments in pipelines: Similar to investments in refineries, such pipelines would be welcomed, but the barriers to their construction has not been lack of investment but lack of approvals to construct.

Investments in high-tech companies, especially those that will create products to sell outside of Canada: That would be beneficial. However, it’s not clear why governments need to play a role in this, or that there is a lack of domestic investment for viable projects.

Investments in auto and other manufacturing: There is probably a benefit and perhaps a large benefit in attracting auto production to Canada that would otherwise occur elsewhere. However, this usually comes only at the cost of heavy subsidies and gets into various governments competing as to which can most heavily subsidise an industry. It’s ultimately a bad idea. If other governments wish to subsidise auto production then perhaps Canada is better off to focus on other things and to simply import the subsidised autos for Canadians to buy.

Investments in housing, retail, office buildings, entertainment, restaurants, banks, utilities, or communication systems: As noted above, few would argue that Canada has any deficiency in most or all of these facilities and services much less that there is any need for government to intervene to attract additional investment.

The bottom line is that I don’t see the evidence that Canada is, at this time, in any particular need of added private sector investment and certainly not beyond what the free market is already providing (which has been excess investment in many sectors) and therefore I see no role at all for government to actively encourage much less subsidise an inflow of foreign investment. The role of government in the private sector portion of the economy is to provide the proper legal framework and then to basically stay out of the way of the private sector. Getting into subsidy bidding wars with other countries for things such as automobile assembly plants is likely not money well spent.

Government Investment to stimulate the economy

At this time there are a lot of calls for the Canadian government to make investments to offset a slowing economy.

I would certainly agree that there are certain things where government and not the private sector is the logical party to make investments. This includes things such as schools, hospitals, public mass transportation, highways, navigation facilities and defense-related needs.

I am also not against governments borrowing money to make such investments as long as the debt and deficits do not get too high. (And with the Canadian government’s level of debt and deficits being relatively low as a percentage of GDP compared to historical peaks and compared to other countries, I do not think the existing debt level is too high.)

There may also be a case for government investments in transfers of money to individuals in certain cases.

The following are my thoughts on various potential government investments that come to mind:

Highways: Canada has almost exclusively relied on governments to construct highways and has allowed both private and commercial vehicles to travel without toll charges. The costs are recovered to some degree by relatively high fuel taxes and to some extent from general tax revenues. A highway system is most certainly necessary to allow people and goods to circulate. And circulation is the essence of economic activity. To a good extent, “free” highways are a part of what allows more isolated towns and small cities in Canada to continue to exist and grow and most Canadians would support that notion. Highways also facilitate the extraction and production of resources including agricultural resources. I think there are areas in Canada where improved highways are needed including twinning of highways. As long as project costs are well-managed I think spending on highways would not be money wasted and that it would be a strong candidate for increased government investment especially in times of higher unemployment.

Mass Transit: Mass Transit systems are necessary to the circulation of people in large cities. They can enhance the value of both the city center and of the suburbs. They reduce vehicle congestion and pollution and they allow people to much more easily travel for work, shopping, recreation, social visits, and entertainment. However, any feasible level of fares charged tend to be insufficient to cover the full costs of these systems. Given that the economy of a city benefits from these systems it seems appropriate that governments invest to cover some of the costs.

Water and Sewer Infrastructure: There are certainly many smaller population centers where the population is not large enough to allow all needed water and sewer systems to be paid for through user fees. Unless the country wishes to see these small centers closed down it seems reasonable for governments to invest in improved water and sewer systems in such places. This type of work can create construction jobs.

Job Relocation Assistance: Canada has long suffered from a resistance of people to relocate to where the jobs are. The income tax moving expenses deduction already provides significant benefits to those who incur out of pocket costs to move and who are in a high tax bracket. Still, getting a tax benefit for say 40% of the direct out of pocket and eligible moving expenses still leaves the individual out of pocket for 60% of those costs and for 100% of various non-eligible costs. (Which could include, for example, a period of interruption of employment especially for a spouse, higher housing costs, and even the costs to travel back to visit family periodically). There are also large social and psychological “costs” and risks to moving. In many cases private companies are not willing to reimburse moving costs even in tight labor markets. To the extent that the entire economy can benefit from increased labour mobility it might be reasonable for government to increase its assistance. For example the tax deduction could become say a 75% tax credit. And the existence of this tax benefit could be better communicated.

Enhanced Employment Insurance Benefits: At a time of higher unemployment it may be appropriate to lengthen the period of eligibility for this benefit.

Reduced Income Taxes for Low Income Earners: Low income earners already pay lower income taxes. Still, the income tax rate on incomes between about \$13,000 and about \$42,000 is 20.05% in Ontario and 28.53% in Quebec. If the government wishes to invest in stimulating the economy then I would suggest a reduction to the marginal tax rates for low income earners.

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Shawn Allen

InvestorsFriend Inc.