Do share prices reflect company performance?

Press, Volume CXI, Issue 32561, 22 March 1971, Page 20

Do share prices reflect company performance?

(By our commercial editor)

The comments on the price of the company’s shares by the chairman of New Zealand Motor Corporation, Ltd (Mr W. N. Norwood) at the annual meeting draw attention not for the first time is to the extent to which a company’s performance is reflected in the price of its shares.

Especially in the last two years this matter is raised fairly regularly by company directors, whereas numerous investors are induced by the historically low level of share prices to wonder if shares are not really worth more. This is, of course, the ageold question of value and price. Why is it that diamonds—which are useless—-

command an exorbitant price, while the air we breathe, which is indeed priceless, has no price at all? The question, posed by Aristotle about 300 years before the birth of Christ (and probably not for the first time even then), is of great importance to the understanding of share prices. But it took a long time to answer it. Economic theory could not satisfactorily explain the paradox until the development of marginal utility theory about 1870.

Without going into the technicalities of utility theory, it may be said that the price of a commodity depends on short term factors: supply and demand (and their determinants), and that in the long run this price will equalise with value, as determined by the cost of production. The same holds for the price of a share, except that a share is not a consumption good, it is an entitlement. Its long run value therefore is determined by the sum of al) its future rewards. The determination of the price of a share is the result of the very complex interaction of many factors Analysis of these factors cannot be without effort, but is worthwhile. First of all, a distinction must be made between psychological and technical factors, and these again must be considered in their short term and long run effects. The psychological factors, although the most difficult to ascertain in practice, are the easiest to discribe: they simply consist of investors’ expectations. Some the technical factors acting on the demand for shares are: in the shorter run the quantity of cash looking for investment, the attractiveness of competing investments, the level of interest rates, the amount of short selling and trading, taxation, and in the long run; the level of disposable incomes, the level of savings, and the rate of inflation in the economy.

This analysis of factors is useful as an aid to understanding, but in practice the distinctions become blurred. Short selling, for instance, is done on certain expectations, although it has techhical effects and the subsequent covering is certainly a technical factor. Similarly the attractiveness of other investments is in part based on expectation, especially in the long run. Tug of war The availability of cash for investment may be determined by technical factors such as a credit squeeze, or by a strong preference of investors to hold cash, because of their expectations. The technical factors, therefore, may in their turn be determined by technical or psychological influences. The supply of shares by prospective sellers is similarly influenced by investors' expectations, need for cash, desire to invest in something else, etc., and in the long run by the total new capital raisings of companies, or allotments in take-overs and other share issues.

These factors each affect the market in a definite direction, and it is often possible to roughly assign a magnitude to them. At the same time they usually result in

a tug-of-war, the outcome of which it may be difficult to predict. For instance, inflation is rampant at the moment, and normally a flight from cash into shares might be expected, resulting in strong demand and an upward trend of prices. But this tendency is offset just now by the bearish outlook and pessimism of investors, reinforced by such technical factors as the credit squeeze; these pull the market down. Therefore, whatever flight into assets there is at present, is in other avenues of investment; it comes as no surprise to learn that property investment is booming. The price of a share may therefore substantially differ from its values, as assessed on the basis of the capitalisa-

tion of all future earnings, discounted for the present, and allowing for such factors as-inflation. This value is only a yardstick, very useful, but of necessity subjective and of no immediate import. Price, on the other hand, is the objective result of the assessment and discounting of all relevant factors by the mass of investors. And as the saying go.es, the market is always right, by definition; a thing is only worth what you can persuade an idiot to give for it.

But part of the fun of investing in shares is to pit your—-of necessity subjective —evaluation against the market data, that is the combined opinion of all other investors. (To be continued)