In the Stock Market, Price and Value are Not the Same Things

In the Stock Market, Price and Value are NOT the Same Things

The stock market can be perplexing…especially recently. Like why does the stock of a world-renowned market leader fall 30%? Or how does the stock of a new company that is losing money go up 50%? The answer may lie in misconceptions about the stock market. Here we clear up one of the more erroneous perceptions.

Published by Motley Fool Wealth Management Wed, Jul 6, 2022

read time 7 min read

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Have you ever played the game two truths and a lie? It’s a game where someone gives you three statements, and you have to figure out which one is false. We're going to play our version right now:

Statement 1: The stock price of many global leaders has fallen a lot this year.

Statement 2: A company’s value diminishes in tandem with its stock price.

Statement 3: Many investors have lost faith in the companies they once believed were true market leaders.

Can you guess which is the lie? Yup, you got it—Statement 2 is false. Before we dive into why let's explain the two truths.

Truth: The stock price of many global leaders has fallen a lot this year.

With 2022 roughly half over, the S&P 500 is down about 20% from its high on Jan. 3, 2022. While that is difficult to swallow, the news is even worse if you look under the hood. Nearly half are down more than the index, and 138 of the 500 companies are significantly worse, down at least 30%.1

Truth: Many investors have lost faith in the companies they once believed were true market leaders.

The broad-based nature of the recent sell-off tells us that many investors have lost faith in true market leaders. Even though many companies have declined more than the indices, the overall fall of the entire market says that these investors are "throwing the baby out with the bath water." Every sector except energy is down this year, and of those down double-digits except for Utilities.

PositiveEnergy

Source: Standard & Poor's. S&P 500 sector performance percent change. Data from Jan. 3, 2002 through Jun. 14, 2022.

Lie: A company’s value diminishes in tandem with its stock price.

Many investors confuse stock price and company value. The stock price reflects a company's fundamentals—such as sales growth, margin expansion, increasing cash flows, or earnings growth. But it also mirrors sentiment—which usually shows itself in the valuation multiple assigned to a stock. More optimistic investors may bestow a higher valuation multiple because they believe future growth will be robust. But pessimistic investors give companies lower multiples. This pessimism or optimism can mirror the individual company's prospects or the entire market's expected growth.

Today, sentiment surveys indicate that consumers and businesses are highly pessimistic. For instance, the latest reading of small business sentiment fell for the fifth consecutive month below the 48-year average of 98. Even worse, owners who expect better business conditions over the next six months decreased to the lowest level recorded in the 48-year-old survey.2 Similarly, consumer sentiment continued its downward trend that began last year and reached its lowest recorded value, comparable to the 1980s low recessionary level.3

Understanding how sentiment and fundamentals influence a stock’s price vs. a company’s value is essential. The chart below shows the breakdown of shareholder returns on an annualized basis for the S&P 500." It depicts three main components that comprise shareholder returns. Two parts are financial fundamentals—earnings (EPS) growth (green bars) and dividends (blue bars)—and one part is sentiment—valuation multiples (orange and yellow bars). You can see that dividends have been relatively stable since the mid-90s, averaging roughly 2% per year. In contrast, earnings growth and valuation multiples have significantly varied over time, although valuation multiples are the most volatile.

StockComponents

Source: Crestmont Research. 10-Year stock market return components from 1900-2021. The total return is before transaction costs. Y-axis shows the annualized return of the S&P 500 Index.

So what does this mean for investors?

When the market multiple contracts/expands, it is generally a function of sentiment rather than fundamentals. That is what has happened this year. At the high of the market on Jan. 3, 2022, the forward P/E for the S&P 500 hit 21.4x.4 Since then, it has fallen to 17.7x.5

That’s not to say that sometimes this contraction isn’t warranted. Of course, some companies never deserved their elevated multiples because they did not have sustainable business models. But even strong companies may experience multiple contractions. Some may have gotten caught in a euphoric fray, and their multiples may have grown ahead of their fundamentals. Others may have deteriorated along with economic conditions that could impact a company’s short-term prospects and result in lower earnings. So sometimes, contracting multiples may make sense for that short period.

But as long-term investors, we don’t get caught in the web of near-term sentiment. Instead, we believe that Quality companies with solid fundamentals should continue along a growth trajectory, even if they hit a temporary speed bump due to the economy. That’s because we think these companies' products and services create value for their customers.

That's why stock prices do not always reflect a company's value.

Just because consumers or businesses feel low doesn't mean a company has necessarily lost its value. It just may mean its stock price has taken a temporary hit. And while it may be painful to take those blows, they also could provide an opportunity to buy Quality companies at fire-sale prices.

So what do we do? We buy what we believe to be long-term winners through these types of sentiment storms and fight back against those pesky emotions!

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Footnotes

1S&P Capital IQ, as of Jun. 23, 2022

2nfib.com, May 2022

3umich.edu, preliminary results for June 2022

4Factset, May 16, 2022

5Birinyi Associates, data from Jun. 10, 2022

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