Stock Prices are Fluid… and Your Valuation Isn’t

The other day we wrote about an article on Medium.  The author posited that public company’s stock price (aka value) reflects all the earnings that the company will ever earn.  (We took umbrage at that notion.)   The author also made the comment: “I used to wonder why stocks moved substantially after earnings announcements…” and that earnings announcements are a “great predictor of cash flows.”

Not entirely sure where she was going with that, but her point is well taken.  Earnings announcements DO have a profound impact on stock prices.  A company “beats the street” and stock price increases.  Miss your earnings?  Price tumbles.

But why?  And more importantly in our world, what’s the corollary for a privately held company?

Liquidty and Substitution

The stock market is all about two things: liquidity and substitution.  By liquidity we refer to the ability to quickly transact a share of stock.  Doing so requires a counterparty that is willing to be the opposite side of your proposal.  Consider this: I have this uncle that sits at home and in between telling kids to get off his lawn trades in one of those funny money accounts you can set up.  He makes a killing.  But poor old Uncle Sal can’t quite pull it together with real money on the line.  You know why?

In the faux trading account… his order always gets filled.

That’s right.  Have 50,000 shares of Apple, and you see that price creeping higher?  Sell now and lock in some gains before it dips.  Maybe before that report on Apple Watch numbers comes out.   Oh wait a minute… seems everyone else has the same idea.  No one really wants to buy my 50,000 shares.  Oops.

Subsitution refers to the alternative choices that investors have.  Apple or Google.  Samsung or Sony.  GE or Siemans.  Shares are bought and sold (usually) not based on dividends that accrue to ownership of a share, but based on the ability to find some other sucker to buy at your asking price.  In a liquid market this is easier to do.  Stock prices move rapidly.

What About a Private Company?

In a privately held company there is no liquidty.  You can’t readily exchange shares on the open market.  Selling private shares is more akin to selling that 50,000 Apple shares: it’s hard to move quickly.   A buyer is more concerned about dividends that acrue to the shareholder.  Earnings are viewed over a longer period and judged based on probability of earning dividends for an investment.

It’s this lack of liquidty and longer term view that smooth movements in the valuation of a private firm.