Stock market trading and human psychology - Part 1

In this entry I'd like to point out something I think people tend to leave out of the equation when they think about stock market trading. The prevailing notion in free market ideology concerning stock markets is that markets correctly value the prices for different stocks. Rational for this goes along the lines that the value for a company's stock is calculated by discounting future profits to the present time and that result is the correct market value of the company. In other words you estimate the profits you expect the company to make in  future years and those profits you value into today's money using appropriate interest rates. And the theory also says that possible misvaluations will be corrected over time by the market itself, so that in the long run the market values of stocks will be appropriate.

It's a great, feasible theory and I myself happen to subscribe to it. However, we should also think how things works in practice. In practice, we don't everybody dutifully do our homework. Or how many of you can say that you've made the appropriate calculations before you bought stocks? How many of you bought them just on the basis of some analyst or some other expert recommending them? Or did you just buy that company's stocks because everybody else is also buying? And did you really calculate the value or did you just compare them with their historic values?

Yeah. That's exactly what I thought. Mind the fact that if nobody does their homework the price doesn't have to be anywhere near the "right" value. And that analyst. You shouldn't count on his opinion too much, because A) he can be wrong or B) he might have different incentives and may not be telling you the truth. In the end it's you who will bear the brunt for mistakes by losing your money and the analyst - he really doesn't care. So, if we all just trust anybody else's opinions, we are in effect blind as bats when placing our bets...

This brings us to the actual point. The value of a certain stock is NOT necessarily the correct market value. It is the price that the buyer IS WILLING TO PAY if the seller is prepared to sell at that price. Even if the price is 10 times what it should be, if somebody pays that price it will become the present market price. And others may blindly join the buyer believing he has some information they don't and therefore we have set a new unrealistic market price for the stock. Human psychology can really do that and has done that repeatedly in the past. I'll give you a concrete example of that a little later.

How do you calculate a company's market value, then? Well, that's not simple. It depends on what kind of business the company is in, what is the amount of required working capital, possessions of the firm, future growth view, feasibility of the strategy, quality of management etc. However, I can give you an easy rule of thumb to determine you're not catastrophically off the mark. Easy rule of thumb is that a company can't be worth much more than 2-3 TIMES ITS YEARLY TURNOVER! At times it might be even worth five times of its turnover, but that starts to be overreaching.

Let's try an example. Nokia's stock ended at a price of 11,40 euros in OMX Stock Exchange on Friday placing the whole company's market value in the neighbourhood of 43 billion euros. Nokia's turnover last year being 41 billion, that sounds reasonable, right? Market value is close to one year's turnover. If other things are fine with Nokia, that is probably a good buy, even. Let's make some other easy comparisons. For example, the profit for 2009 after taxes was 1,2 billion. So, if Nokia would want to buy all of its shares back from its owners at these prices and levels of profit, it would take 36 years, right? That sounds like a long long time and there wouldn't even be any interest included...

What about year 2008? Turnover was 51 billion and profit 5 billion. At least the payback time would diminish greatly from 36 years to a little less than 9 years at that profitability level. I will leave you to ponder Nokia's value on your own, now...

To the example I promised. Here I rely mostly on my memory, so I hope I don't make too big mistakes here. A company named TJ Group issued its Initial Public Offering (IPO) for investors in early 2000. The price of stock was set around 19-20 euros per share according to my memory. I calculated at the time the resulting market value and decided it was badly bloated. I remember calculating that the company would need to grow its turnover 40- or 50-fold before it might "fill" that market value. So, in my mind, it was mostly hot air. I didn't believe they would grow that much any time soon and the profitability level wasn't too promising, either.

Quite many others did believe in the company and it collected 237 million euros from investors in its IPO. And that with a yearly turnover (1999) of only 11,4 million euros! According to the rule of thumb I presented you previously, this company could have cost from 11,4 to 34,2 million euros (1-3 years turnover) or at it's most 57 million (5 years turnover). Sadly, the company lost about 97 % of its market value in about one year after its Initial Public Offering...

So, I am rather proud that even in that "dotcom" -market frenzy and with experts trumpeting the "new economy" and the "new rules", I did my homework and didn't buy into that. Instead, I bought into an IPO of a company called Aldata. That was a sweet buy, for it took only half a year to rise tenfold. I also bought Basware, but sadly it was too popular. Too many people bought Basware and my purchase ended up being only about 5 % of what I wanted. It was too small a share to mean anything and I sold it fast.

That's today's lesson, folks! I hope you appreciate the possible disconnection between theory and practice. Here's couple of extra points to take home:

- Theory never represents reality with great accuracy
- Law of supply and demand, as well as human psychology, affects stock market pricing, it's not just the free market theory that counts


Here are some links to refresh your memory:

Listalleottoesite - TJ Group Oyj (2.2.2000)
HS: Tilman ja Salminen TJ Groupista pidätettiin