The Rationale Behind Irrational Stock Prices

The movement of stock prices has been, and will forever be, a bit alarming. It’s not unusual to see a stock up 50% over the course of a year, or down 50%. Recently Weight Watchers stock doubled in a single day after Oprah announced that she was endorsing the company. Although some of this movement can be attributed to the “madness of crowds”, much of it is driven by somewhat rational behavior.

The classic economic definition of the value of a stock is today’s value of all future cash flows (this is similar to earnings). Using this definition over the next 20 years, I computed the value of a stock with cash flow of $1/share at different expected growth rates. The graph below shows that at 0% growth the stock would be worth $16/share. At the other extreme, 15% growth would imply a value of $77/share. Even small changes in the growth estimate can have a large impact on the price. For example, at 4% growth the value would be $24 and at 6% it would be $29, a 20% change in the stock price with just a 2% change in the expected growth.

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Of course, no one knows what the future holds and how much a company will really grow. Growth projections for large well-established companies, such as IBM and Wal-Mart, don’t change much and their stock price movements are fairly small. But for small and/or new companies, such as Tesla and Netflix, the future is much harder to predict. Their stock prices might move dramatically with new information on the company, industry, and the economy. What may seem like a minor announcement can have major implications when the future is factored in.

The same is true for the market in general. Recently China was in the news as the market tumbled. The thought was that slowing growth in China would reduce future earnings growth for all companies worldwide.

Calculating the correct price for a stock is more art than science. The difficulty is in accessing what the future holds for a company, its industry, and the economy. Small changes in future expectations can instantly and dramatically affect the price of a stock since it can have a large impact on earnings far into the future. Although investors may be irrational in their future expectations, as they were during the dot-com bubble, the way they price these future expectations into a stock is perfectly rational.