Fool's Eye View

[ November 10, 2000 ]

What's The Real Value Of A Share?

By Nigel Roberts (TMFNigel)

Chippenham, Wiltshire -- We spend a lot of time and energy here at the Fool encouraging everyone to take control of their own finances, to do their own research and to make their own decisions. A lot of this often resolves around trying to determine the correct value of a particular company and trying to buy it at "the right price".

But what really is the right price for any particular company? Most people would probably define it as when the market is undervaluing the business. But is it ever right to say that a company is undervalued?

What really decides the share price?

There are all sorts of factors that help to determine if a company's share price goes up or down: is the company's management any good? Are the products good? Does it have excellent future prospects? Is it a takeover target? Does it have undervalued assets? Are the costs of its raw materials going up? Is the company going to be affected by new laws? Have the shares been recommended as a "buy" or "sell" by share tipsters?

While all the above things may help to determine the movement of a a share price, what really and finally sets the share price is the price that someone is prepared to pay for the share. This may seem a simple statement, but many people often seem to forget it.

If you spend a lot of time analysing a company, and eventually conclude, based on your own assessment, that the share price of a company undervalues its real worth, and you decide to buy shares in the expectation that the shares will soon be re-rated, you then have to sit and hope that the rest of the market eventually comes around to your view. And you may be in for a long wait!

What is the correct price of any share?

Let's have a look at some of the dot-com shares. When Lastminute.com (LSE: LMC) peaked at 488p soon after its flotation, were the shares massively overvalued? Now that they have hit a low of just 82p, are they massively undervalued? What about my own favourite stock, Baltimore (LSE: BLM)? At the start of last year the shares were trading at a lowly 47p; in March this year they hit 1375p. If you bought the shares in January 1999, and sold them in March 2000 you would have made a staggering 2800% profit. Mind you, if you had bought them at 1375p in March and sold them now at 463p you would be sitting on a loss of nearly 70%.

What is the correct value of Lastminute.com or Baltimore? Was Baltimore massively undervalued in January 1999? Was Lastminute.com overvalued in March 2000? Was Baltimore vastly overvalued in March 2000, as so many people now appear to think? What was the "correct" price of the shares? Both Lastminute and Baltimore have been left mostly unchanged following their share price falls; the businesses are pretty much the same as they were, and in fact both have continued to advance. So why have the share prices changed so dramatically? Nothing else about the companies has changed: the management is the same, the products are pretty much the same, and the future prospects for the companies remain quite bright.

The only difference is that in March people were prepared to pay ever greater amounts of money for the shares, whereas now people either do not want shares in these companies at all, or they are only prepared to pay a lot less for the shares.

So what is the real value of the shares?

A share is only worth what someone is prepared to pay for it. A share does not have some independent, guaranteed value of its own, regardless of the views of investors. It is only worth what the next person is willing to pay for it.

Imagine you have a company in the UK, making the exactly the same product as a company in Japan and a thirdcompany in America. Each has much the same profitability and future prospects. The UK company trades on a P/E ratio of 12, the US company on a P/E ratio of 25 and the Japanese company on a P/E ratio of 100. Is the UK company undervalued and the Japanese company overvalued? Is the US company the only one that is correctly valued?

The P/E ratios are quite simply what investors are willing to pay for shares in any particular company; so whatever the P/E ratio, the share price at any given time is, quite simply, the correct valuation of each company. It reflects what, in the real world investors are willing to pay to own a share of the business.

Shares are commodities

Too many people believe that shares have some sort of mystique -- that shares are somehow "different" from anything else that can be bought and sold. They aren't! There is no mystique over buying and selling shares. Market forces determine the price of a share. If more people want to buy the shares than want to sell the shares the price will rise until sellers match buyers. If more people are selling than buying then the price will fall until buyers emerge. When buyers and sellers are matched then the share price can be viewed as "correct".

Shares do not have an independent worth of their own any more than a house or a car has any specific intrinsic value. I can hear Fools everywhere screaming "of course houses and cars have an intrinsic value!". But they don't! If no one wants to buy your house or your car, what is their real worth?

The same is true of shares. What actually moves the share price is what people's perceptions are of where they think the share price should actually be. If enough people do not share your view of a share's worth, then the share price may not move in the way you want it to.

Where Next?

• How to value shares