How Market Prices are Set

This week I talk about the important concept of market prices.

 

VIDEO SUMMARY

In the last video we talked about the investment decision-making process and how it is important to identify mispricing in the market. That leads to the next logical concept, which is “what are market prices?”

Today it is really easy to access market prices. You can go on any financial website. You just go onto the internet and you can find the current market price for any stock. But I think it is valuable to take a step back and really think about where these market prices come from. This understanding should influence your decision making process.

When you are talking about mispricing in the market, there is this big theoretical argument that a lot of people get into on whether or not markets are efficient, and to what degree you can find mispricing in the market. What I would like to do is set that argument aside for the moment and just talk from a practical standpoint about how these prices come about.

Let us start with a very simple definition of price. What is a price? What I suggest is that the price of something is your perceived economic benefit that you are going to receive from an item or a service. I use the example of a machine. Let us say you were to build a machine and this machine costs you one million dollars to build. The price of that machine, if you were to go out and sell it in the market, would not be one million dollars. It would be based on the value that machine creates for your customer. Let us say this machine that costs all this money, but does not actually do anything of value for anyone. Then the machine is worth zero dollars. It does not matter how much money you spent building it. The price is based off of the perceived economic value of something.

Let us extend this definition of price to the example of a business. When you are investing and you are buying a stock for instance, what you are doing is you are buying a piece of a business. The price you pay should reflect the value of that business. So if you are going to buy a business, how would you determine the price? You would look at the organization and you would say, this organization is going to generate a series of future economic benefits. Every year they are going to make so much money. If you forecast out these future benefits and then value those benefits back to today, that value should be your price. This is where it gets really complicated, because to determine your prediction of all these future benefits, you are making all kinds of assumptions about the future. You are trying to predict the future. You might think the economy is going to do well, or you might think the economy is going to do poorly. Whatever your assumptions about the future are going to impact where you set your price. How much will you be willing to pay for something based on how much economic benefit you think you will get for that price?

Let us look at the example of market prices. When you pull up the internet, and look at the price of a stock, where is that price coming from? That price actually comes from the buying and selling of stock transactions. There are all these transactions going on where people are buying and selling at different prices. All that activity ends up at the current price. So what that number that you pull up represents, is the result of all these transactions. What is important to realize is that the transactions are a result of many, many, many different investors all over the world making these assumptions about the future of this organization and arriving at a price. They are not just thinking about what they think is going to happen in the future. They come to certain conclusions that they are so sure about that they are actually going to put down money and purchase the stock at a specific price. That is a very powerful statement. I just want people to absorb what that means. The current market price is what everyone in the world has arrived at by coming up with their assumptions about the future.

Let us bring this back to you, because this says a great deal about your particular investment. If you come along and you say, “I have identified an opportunity that I think is a good investment.” You are saying you can get a good price for something, so therefore there is some mispricing you have identified in the market. You want to make this investment. Just realize what a huge statement that is. The market price is set based off of everybody’s assumptions in the entire world and you are saying you know better than everybody else, and all these other professional investors. That is a huge statement. Do not misinterpret what I am saying here. I am not saying you should not invest in individual stocks. I am not saying you can’t identify mispricing. What I am saying is you need to respect the gravity of the decision of investing in a stock and just realize the arrogance of the sheer action of doing this. If you invest, you are saying you know better, and you know something that everybody else in the world does not know. It is based on your assumptions. This is why assumptions are so powerful.

The market price is set at a certain level, and this is based out of everybody’s assumptions. You come along and you have a different set of assumptions, so you think the price should really be higher. Well this is a huge opportunity, because if you buy down low and the stock should be valued higher, the stock is currently undervalued. So when the stock price corrects to the appropriate value, you are going to make money. What you want to do is clearly document what these assumptions are. Clearly document your understanding. The current price suggests a certain set of assumptions. Figure out what those assumptions are everybody else is using, then document your assumptions to understand the differences. Then you can be very clear about why you are making this investment decision. If you can’t identify what those assumptions are, maybe it is not as good as an investment as you think. The other benefit is if you can identify what the difference is, then you can know at the time you purchase the stock how much money you expect to make. The point I really want to make about market prices is just to gain this understanding about where these prices come from and what it means when you go in and make your investments.

I want to give a word of warning. You should realize that there is some intelligence in the market. If you come in and you think you have identified a mispricing, some stock that is undervalued in comparison to the rest of the sector, sometimes there is a very good reason why it is undervalued. So just because something is undervalued, it does not mean it is always a good investment. You should try to understand what the market is telling you versus what your assumptions are. If you can identify people’s assumptions, you can better identify prices and make better investments.

To recap, we started by giving a definition of price. We extended that definition to talk about what the price of a business is, and then talked about the process of how market prices come about, and why that is important in investing.

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Neither Zach De Gregorio or Wolves and Finance Inc. shall be liable for any damages related to information in this video. It is recommended you contact a CPA in your area for business advice.