Fashion trends in Stock Market valuations

Logically, equity stock market valuations should always be based upon fundamental reasoning and calculation, but, the way these calculations are made can be greatly influenced by currently fashionable trends in business strategy.

Until the late 1950's, equity valuations were based upon the actual returns a company was likely to provide in the way of dividends to the shareholders. No account was taken of profits used for future business. Equity share prices were based solely upon the discounted value of actual incomes with allowances made only for any risks that dividends might not be maintained.

This put the onus on the directors and executives of a company to do everything in their power to maintain the profitability of the company to the extent that dividends were fully supported by earnings and with sufficient reserves to give confidence that dividend payments would be maintained every year into the foreseeable future.

This worked fine while dividend yields from equities were greater than the yields from fixed interest bonds but then IBM came along. The price of IBM shares started to increase substantially without the company paying any dividend at all. This shocked investors into realising that the value of a company was not based solely upon what it was paying in the way of dividends in the present, but, also account must be taken of the potential for increased dividends it may be able to pay at a future date.

This realisation totally transformed the model for evaluating businesses. No longer was the emphasis put on a company's ability to maintain a steady and reliable dividend payout; instead, valuations were based upon an assessment as to how successful a company might be in finding and developing new projects where the results would realise a substantial profit over the expenditure.

This changed the emphasis of company management from that of preservation to that of expansion. The payment of dividends became of lesser importance than the ability to invest earnings into new projects. This trend eventually reached a stage where the payment of dividends was seen almost as a sign of failure by the company to find new opportunities to expand.

This change in the investment model made the dividend yield an irrelevant ratio for estimating equity share values. Accountants decided that the true value of equities needed to be based upon the bottom line: the net profit that a company was making. This was known as GAAP (Generally Agreed Accounting Principles), which saw earnings per share as the principle basis of a company's true value.

The problem with GAAP though was that any investments in future projects would be deducted from the bottom line: effectively writing them off as if the projects were doomed to failure. It allowed no valuation for the effects of strategic marketing plans that gave long term benefits; it attributed no value for expenditures on research and development and it placed no value on branding or good will. In effect, the GAAP valuation of a company was the liquidation or breakup value.

The smarter investors soon spotted these anomalies and there were many highly profitable takeovers before accountants woke up to the fact that they were undervaluing their companies in some way..

To compensate, the accountants started to add a nebulous component to a company's value – known as "intangible assets". This figure included all the expected future benefits that could be realised through current advertising and marketing; employee training; good will; branding; research and development, etc. No provable evidence could be supplied to support the valuations given to these intangible assets, but, their addition certainly provided a more accurate valuation of a company as a going concern.

The problem, however, was that this nebulous asset allowed all manner of discretionary additions to be included in company valuations. It led to much "creative accounting" where a company could be given any kind of value according to how the directors and accountants measured the intangibles and the elements of risk associated with them. This led to the bizarre situation where companies could continue to show continuous losses on their balance sheets while their equity share prices continued to rise.

Until the advent of the Internet and the World Wide Web, intangible asset values, although not precise, were usually based upon some kind of generally accepted, common sense reasoning. Most of the factors and their consequences were more or less understandable; outcomes and risk were predictable within a reasonable degree of accuracy.

The coming of the technological and communication revolution threw these valuations of intangible assets into confusion. It involved dealing with a technology that few if any of the investment analysts, accountants or investors understood. Valuations involved unknowns and unknowables, unpredictable events and technological changes. Effectively, this made the valuation of intangible assets a matter of total guesswork: allowing the imagination to run riot.

The problem was that the promise of potentially huge profits that might be made in a massively connected world had fired the imagination of investors. The potential for profit seemed to be without limit. Fantasy started to creep into the valuations of intangible assets. All common sense was thrown to the wind with equity share valuations changing rapidly from being based upon earnings per share to being based upon dreams per share.

The most surprising feature of the dot-com boom was the way in which many respectable and long established stockbroking firms subscribed to the dreams per share method of calculating values. They could almost have been prosecuted for fraud and misrepresentation for some of the IPOs they put together. However, allowance has to be made for the fact that stockbrokers are in business to give clients what they want and, with such a huge demand for technology stocks, they had to provide them.

The buying and selling of equities is purely a zero sum game where winners win what the losers lose. As such, there is no strong pressure to keep prices at fundamental levels. There is no convincing argument that an equity price is too high if somebody is willing to buy it at that price.

If some stockbrokers were basing IPO prices on dreams, others had to do the same to be able to maintain their share of the new issue market. Although traditional methods of evaluation indicated these valuations were incredulously large, there were so many takers of the equity offerings coming onto the market that IPO equity prices expanded beyond all reason.

When these initial public offers were being bid up as much as several times their offer price by the market , the brokers assumed that they must be doing something right and continued to value IPOs at increasingly unrealistically high values.

But, of course, it couldn't last.