In Financial Models, we introduced the concept of the Value of company. This Value is measured with money and it is changing in time. The "price" of the company - its market capitalization in the case of publicly traded company, is a tool of distribution of this Value among market participants.
Because the Value of company is changing in time, the "price" of the company is established based on forecast of the Value.
We discount in time the estimate of future Value and we take in consideration mistakes of forecast by using average values. This procedure is done implicitly by the market (price discovery) or explicitly by the market analysts.
In the case of description of the market functioning, this introduction of a new concept allows consistent explanation of seemingly unrelated factors.
In the case of market analysis, this allows the separation of different factors:
and clarification of existing models and introduction of new models useful for the forecast of stock prices or the estimate of a purchase price of a company.
Here we further analyze the nature of this concept and its applications.
The moment a business is traded, it acquires properties of products and services traded on the market. A price of a product cannot be deducted from its functionality, services, which it replaces and cost, which is reduced with its help. Similar, the price of the company cannot be reduced to the price of its assets and the cash flow, which the company generates.
Because of it, a society needs a market, where the price is "discovered". This price reflects the Value of product or the Value of company.
This Value is defined from the point of view of society as a whole. It cannot be estimated from some local point of view. An analysis of usability of a product or profitability of a company is never enough for a price estimate.
In some simple cases, where market conditions are stable, there are empirical methods, which can be used to estimate a price of a product or a business, without going through process of market negotiation.
However, this approach does not work in general.
Often even more sophisticated method of arriving to a price of a business through pricing of its parts does not work; because a price of a whole can be much more or much less than a sum of its parts.
We have to accept that the Value of company is a Basic Concept. It cannot be reduced to other concepts. Attempts to avoid an introduction of this (or similar) concept as a Basic Concept inevitably leads to difficulties in interpretation of stock prices observed on the market.
Our Forecast Model combines forecast of the Value of company and its price (market capitalization). This is an inevitable approach, because we observe prices and we do not observe the Value. An introduction of the Value of company in the forecast model makes this model more precise, because it better reflects the situation, which it models.
We compute the current Value of company from its market price using our model. After that, we forecast the Value of company and use this forecast to forecast the market price of company.
To forecast the Value of company, we need to find factors, which determine the change in Value of company.
In established market sectors and in slowly changing market conditions, there are known factors, which allow such forecast: assets and liabilities, revenue and cost, market share, etc.
However, in a society, which changes fast, which economy is changing fast, we need to take in consideration factors, which were never (or rarely) included in such analysis before.
These factors reflect business'
Importance for Society
We start with the factor, which is most difficult to accept from the point of view of prevailing economic thought - importance of the business for the society as a whole.
Recall the period of introduction of personal computers and the rapid growth of market capitalization of companies involved in this business.
In the moment of their introduction and many years later, the price of personal computers was not justified by their usability. Computers were used mostly as typewriters.
A market capitalization of computer hardware and software companies was not justified by their profits. We still see P/E multiples in this industry, which are higher than in other industries.
Hence, the Value of computers and the Value of companies in this industry cannot be deduced from immediate usability of the product or profitability of the company.
A valuation of product and a valuation of company are based on their "usability" for a society as a whole. The product's immediate usability for customers and the company's profitability affect the valuation, but not necessarily define it.
This argument can be reinforced with an example of the market of art forms. Market prices of art forms hardly can be deduced from their "usability". Nevertheless, this is a stable market. These prices are defined by "usability" for a society, as whole, not immediate benefits for a particular individual.
The importance for society is difficult to measure (if possible at all). This creates preconditions for famous mistakes of forecast, as an IBM's forecast that "there is a market for not more than five computers". Market analysts are facing now similar problems, when they try to forecast the development of new sectors of economy based on the Internet.
The solution is in analysis of the market responses and in measuring Importance for Society through such analysis.
In a rapidly changing economy, a business expansion is defined by its ability to use newly created opportunities. This requires foresight, technology, ability to make risky decisions, and flexible business infrastructure.
These abilities allow an expansion, which outpaces an expansion of "traditional" businesses.
The expansion of the economy as a whole defines limits of company's expansion. This is a factor, which can be and should be used in forecast of the Value of company - slowing expansion of economy as a whole means fewer opportunities for the company to expand.
In a slow changing economy, the survivability of a company is defined by its ability to withstand small changes of economic environment and carry its identity. Usually, the high level of survivability is achieved by maintaining a viable bureaucratic structure of the company and a substantial cushion of cash or available collateral.
In a fast changing economy with potential of periods of sharp contraction, the survivability is defined by the ability of company to reduce its expanses sharply for a period, without loosing its identity.
In a changing economic environment, a business' ability to adapt becomes a crucial factor. The very property of a business, which allows it growth in the slow changing economy - its stability, delivered by the bureaucratic system, becomes its disadvantage.
If a business cannot adapt fast in the environment, which is changing fast, then it can loose even in the absence of serious competition, simply because of the change of the structure of the "demand".
Creation of Value
If the business, which creates new Value, is a part of a company with the strong bureaucratic control, then a simple spin off of such business into a separate business entity, can create new Value by creating more favorable conditions for decision making in changing situation.
There are barriers on the way of creation of new Value in companies adapted to function in stable conditions. Characteristics, which are used to evaluate activity of their management do not reflect this new Value, they were formulated in different market conditions.
For example, creation of the Internet presence of a traditional company, which allows higher convenience for customers and better information for investors, requires some expenses and does not generate any revenue. The positive effect of such activity is reflected only in higher stock prices of the company, but this is not used as criteria for evaluation of activity of managers. It is difficult to establish a system, which assures high quality of such presence without familiar feedback from the market.
Hence, such activity can be initiated only by top executives of the company, who are sensitive to stock prices.
For example, artful appearance of Apple computers did not bring anything to the "bottom line", but it propelled Apple's stock. This appearance could be brought only by a top executive with a broad view of a business.
Support of Java, which is provided by Sun Microsystems, does not bring revenue to the company, but affects its stock positively.
It seems to be a general pattern - in a fast changing economy, a new type of Value can be created only with explicit support of top executives, who have a broad view of the market. Members of the bureaucratic system of the company cannot afford this broad view.
Price of Stock
The Value of company is distributed through the mechanism of pricing and dividends. Companies, which create new types of Value, usually do not pay dividends; hence, we focus on the case, when the company does not pay dividends.
The price of company reflects the forecast of growth of the Value of company. It is determined by the speed of such growth.
The price of a share of stock is determined by the price of company and by the forecast of stock issue dynamic. Usually, the stock issue dynamic is presented with the current number of shares, the number of shares sold to public already, and the speed of issue of additional shares (including granting of stock and options, which has to be supported by the issue of additional stock).
To be able to sell stock to public, the company has to manage a combination of the speed of growth of its Value and the speed of issue of additional stock that the price of a share grows with the speed sufficient enough to make it attractive to investors.
General market conditions affect the potential growth of the Value of company.
Interest rates define the speed of growth of the price of a share, which makes stock attractive to investors.
The degree of uncertainty of forecast of the speed of growth of the Value of company and the speed of issue of additional stock defines the correction, which has to be made, when the price is determined based on such forecast.
From this description of the stock pricing mechanism, we can derive some general conclusions.
The minimal rate of growth of the prices of a share and the anticipated speed of growth of the Value of company place restrictions on how much of additional stock can be issued and on the dynamic of such issue.
The company, which does not generate enough revenue to cover its expenses, has to sell its stock as needed to cover the shortfall. We had shown that the issue of additional stock is limited; hence, the possibility of extensive expansion of such company is limited. Obviously, this does not limit possibilities of creative expansion through creation of new types of the Value of company, which does not require big expenses.
Now we forecast the change of the Value of company and we forecast separately the change in the number of shares of stock. This gives us ability to forecast the change in the price of one share (we ignore splits).
Ordinary, we assume that the relative speed of accumulation the Value is constant; this means that the Value grows exponentially.
We can assume that the relative speed of issue of new stock is constant; in this case, the number of shares grows exponentially also.
Hence in this case, the Value of company per share is changing exponentially.
In a fast changing economy with high level of uncertainty, we need a new approach to forecast of the Value of company. We apply to forecast methods used in the risk management.
First we define a few scenarios of general market development and development of the company. To each scenario we assign a probability that it happens (the sum of probabilities should be equal to one - we should cover all possible scenarios).
For each scenario we use traditional methods of forecast (see Financial Models).
We combine results of these forecasts using probabilities assigned to scenarios.
This is a mechanism, which analysts use explicitly and the market uses implicitly. When Fed's hint that they want to increase interest rate, this increases the probability of the scenario of higher interest rates and drives stock prices down.