Current price versus fundamental value

In the early 1970's, I wrote a course on investment strategy for a London firm of investment advisers who were setting up a college to teach students the art of investment. The approach I took was to start by explaining to the students how to calculate fundamental investment values so that they could use these theoretical values to make judgements on current market prices of stocks and shares.

This technical method of valuation involved calculating expected future earnings and comparing the value of those earnings to the current price of annuities (fixed incomes that continue into perpetuity).

Note: The value of any income is calculated by discounting all future income payments back through time to the present day. It's like compound interest in reverse where each payment in the future is given a value according to what sum today would reach that payment amount through compound interest at the time the payment is made.

By suitably discounting for risks and inflation, this appeared to be a logical approach to investment valuations because it was comparing like with like, i.e., one income stream with another. However, when I came to apply this valuation to current equity prices at the time I wrote the course, I found it gave answers widely off the mark. Equity share prices were two or three times the value my calculations were indicating they should be.

At first I thought I'd made some silly mistake in my formulae or missing some important factors, but, despite a month of going over the calculations and methods I could find no obvious errors. So, with great trepidation I let my recommended calculations stand, fearing that as soon as the course went out to the students someone would spot the fault and expose me as a charlatan.

Much to my surprise, I had no adverse comments even though the valuations remained way out of line with current prices for four years. Then, in 1974, the Arab oil crisis occurred. Within a few months there was a stock market crash, prices on the London stock exchange fell by over seventy percent. When the market eventually recovered, the equity share prices recovered only to their fundamental values: the values calculated by the methods I'd proposed in the course.

What I hadn't realised at the time I'd written the course was that it was at a time of a stock market boom. Illogically, the equity prices of all shares had risen to unprecedented levels, way beyond their fundamental values.

I never did get to understand how the prices could have been out of alignment with fundamental values for so long, or, why it had taken a special event to bring them back into alignment. However, the experience gave me a healthy respect for fundamental valuations and a lack of trust in current market prices.