With the market finally delivering its long-overdue correction, it’s comforting to recall Warren Buffett’s statement: “Stock prices rarely reflect the true value of companies. When it does happen, it’s an accident.” Say again? What do stocks represent if not the value of the companies we have in our mutual funds and investment portfolios?
In 2001, one of my weekly columns explained “marked to market,” which is the mechanism through which every single share of stock in a public company is valued from second to second throughout the day. The day’s “closing price“ is the price per share reported for the last sale of the day. All shares are effectively “marked,” or valued, based solely on the price of just those being sold on the stock exchange — an extremely small fraction of the total.
A typical public company has just a thin sliver of its total shares changing hands on exchanges throughout the day. Yet, this thin sliver of all the outstanding shares determines the total value of all the company’s shares. In simple terms, if company ABC had issued a million shares, and 100 of them happened to trade on a given day, the sale price of those that were bought and sold determined the price of all the shares. If our favorite mutual fund happened to own company ABC’s shares, any change in the share price would be reflected in the value of the mutual fund’s holdings at day’s end.
The only time the share price reflects the true value of the company, the ‘’accident” to which Mr Buffett refers, is when the entire company is being sold — not just a fraction of its shares on Wall Street. At this point, it is not an “accident” because the true value of a company is determined thanks to the fact that “a willing seller and a willing buyer” have agreed to a price for the whole company.
While the marked-to-market pricing model is less than perfect, it’s the only thing we have. Its soft underbelly is that amateur investors, self-styled investment experts, financial pundits, market timers, stock manipulators, high-frequency traders and a host of other camp followers all get to influence the demand — and therefore the price — of stocks from second to second. Everything from sheer panic to irrational exuberance can drive prices up and down by as much as 10 percent to 20 percent in relatively short periods. By now, we all know what this looks like.
By comparison, a group of seasoned merger-and-acquisition specialists will spend months developing spreadsheets to convince themselves that an entire company is worth purchasing — and if so, at what price. A few shares selling on Wall Street have little or no influence on that transaction. The price per share is therefore not “marked” to the market price.
A company’s shares have a value that is solid. We can weigh them on a scale of sorts based on the income statement and balance sheets showing profits and asset values. The shares sold on public markets, by comparison, are valued based on public sentiment, which is influenced by the characters mentioned above.
The average person making constructive decisions over time about managing his or her investments needs to know as much as possible about the underpinnings of the financial tools that will lead to success. Common stocks play a critical role in helping people build nest eggs faster than the rate of inflation. Having the confidence to depend on something that can feel like a casino atmosphere requires a leap of faith. But the leap can be shortened by developing an understanding of stock market history, including the “snap-back” after corrections as well as mechanisms like marking to market that contribute to heart-stopping short-term disappointments.