Dec 2nd 1999
From The Economist print edition
The penultimate article in our series of schools briefs about finance considers how shares and stockmarkets should be valued by
WHAT is the value of a share of a company? This innocent-seeming question is a source of endless difficulty and controversy. One answer is
clear, of course: the value of a share is the price it commands in the stockmarket. That is true enough, but not very satisfying. Share prices
move around erratically, often for no apparent reason. Fundamental value, one supposes, should be more stable. And prices are not in fact
entirely random: they seem anchored, albeit elastically, to some underlying notion of worth. That is why, amid all the chaotic fluctuations,
unexpectedly good news about company profits moves prices up, not down. Fundamental forces are at work—but how are they to be
assessed? How are investors to measure the underlying value of a share?
Economic principles (and common sense) suggest that there must be two basic components. First, the flow of income that the owner of the
share can expect to receive over time. (A share that will generate no income in any form at any time is fundamentally worthless.) Second,
the rate at which this flow of income received in the future should be “discounted”, so that it can be compared in “present value” terms with
income received today. All of the many different methods used by market professionals to value equities can be understood as attempts to
gauge these two elements.
Shares would be much easier to value if investors received all their income from them in the form of dividends, and if they knew what those
dividends would be year by year from now until the end of time. They would add up this infinitely long series of flows, discount it (let us
suppose, for now) using the interest rate available on some alternative riskless asset, and thus calculate the present value of the income
stream.This value would in turn be the share’s underlying worth.
But the world is more complicated than this. The first and biggest problem is immediately apparent: nobody knows, in fact, what the flow of
future income from any share will be. So the first component of valuation calls for a forecast—and the scope for error and disagreement is
You would expect firms that do well to pay bigger dividends in future, and firms that do badly to pay smaller ones, or maybe to go out of
business. Looking at the present level of dividends and supposing that it will persist indefinitely is therefore not a sound basis for valuation.
Moreover, a growing number of firms do not pay dividends at all. So a more plausible guide is earnings (that is, profits). If a firm is profitable
now, it has the means both to pay its owners a dividend and to retain some resources for investment. Retained earnings allow the company
to grow, and provide the wherewithal for higher earnings and dividends in future. Earnings, in other words, provide the means to pay income