Thursday, November 4, 2010

What is the Correct Stock Price?

How is a stock's price determined?  I looked at SmartMoney.com's price evaluator and here's the definition: "Our Price Check Calculator can help you estimate a fair price to pay for a stock based on three main things: the company's earnings, the rate at which those earnings are projected to grow and the stock's volatility."  So, it's determined using earnings, projected earnings growth rate, volatility. I also looked at MoneyChimp and they had a formula I got lost in.  I went to Wikipedia and found this for the P/E ratio, just part of what goes into determining a stock's price:
\mbox{P/E ratio}=\frac{\mbox{Price per Share}}{\mbox{Annual Earnings per Share}}
I went through all that for a reason. The pieces of each formula are reported quarterly. So if either of these is the "correct" formula for determining stock prices, why do stocks fluctuate by the minute? For example, if the formula was A x B + C/(DxE) = T, if A thru E don't change, then T should not change, right? What if T constantly fluctuates? That would mean the formula must be wrong.  I think the very smart people that came up with these formulas were trying to get close to actual price of a stock, using all known current information, and they explain their misses as buying opportunities (the stock is priced lower than the formula determines) or buying at a premium (the stock is priced higher than the formula determines).

Here's a very loose example. Say I decide I want a way to predict/estimate how heavy passenger vehicles are that come down a certain road. I assume a certain load per vehicle based on the tire size and multiply by 4.  Later, when I check my results against the actual, I find that sometimes my results are too high, sometimes too low.  So I decide that the formula is right, the tires are over or underinflated.  The problem is not with my formula, reality is wrong.  Yeah, that makes all the sense in the world. But that's the equivalent of what's being said when the experts say a stock is over priced or under priced based on the assets of the company, projected sales, etc.  The price of the stock reflects what someone is willing to pay for it at that moment. Period.

Speaking of charts, I put the following chart together comparing the prices of all my holdings since the beginning of the year. I haven't held each of them that long, but I wanted to see in general which way my portfolio was heading.  What this tells me is that, with few exceptions, my portfolio, and probably the market in general has been headed up most of the year. I think we're probably about to have a good run for maybe the next year or two.  Fortunately I'm in the game.

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