Value concepts regarding stock price theory

Terminology: Value concepts regarding stock price theory

The terminology is used in the following exhibitions about stock price theory

Exhibition: Why the equilibrium stock price is fluctuating
Exhibition: Why tough disclosure laws / rules decrease stock price fluctuations
Exhibition: Why excessively dispersed ownership increases stock price fluctuations
Exhibition: Private or public ownership - The effect on enterprise valuation

Fundamental corporate value

The fundamental value of a corporation is the best possible estimate about the present value of expected corporate income. Such estimates are produced by fundamental values analysis. More info here.

Stock price / fundamental value

The value index measures the stock market price in terms of fundamental corporate value. The latter is defined as the market price that would prevail if the cost of gathering and processing information were zero. Alternatively, the fundamental value is the market price that would prevail if all the market participants were perfectly informed investors. Consequently, an index value of 1.5 means that the stock market price is 50% higher than the fundamental value of the firm.

Equilibrium fluctuation band

When information about fundamental value is costly to obtain a certain fluctuation level or band must associate the market equilibrium price. Somewhat paradoxically, fluctuations are needed in order to motivate informed investors to prevent prices from fluctuating even more! This is very different from the perfect market economy model where information is costless so that prices do not need to fluctuate to be in equilibrium. More info here.

Reported book value / true book value

Reported book value to true book value is an index that measures how far away the reported book value such as equity or invested capital is from the true book value. The true book value is defined as the book value that could be produced if no expense was spared and if there where no biases in the value caused by opportunistic manipulation of value or by biasing accounting conventions. An example of an accounting convention that bias reported book value from true book value is the treatment of marketing and R&D expenses. Such expenses are investments because they have positive effects on the firm's income several years after the expenses have been made. Nevertheless, most jurisdictions require such investments to be written of immediately at the earnings account and it will therefore not be posted on the asset account. As a result the reported net earnings and assets are less than the true earnings and assets. The reason for having such law-enforced biases is usually to protect investors by limiting the number of ways that firms can use to manipulate reported values. Despite of such biasing-precaution-conventions there are plenty of opportunities left for firms to manipulate the reported book values, and that they also have incentives to do so is argued below:

Legally forced valuation bands

The red valuation bands indicate that there are legally imposed limitations as to how far away the reported book value can be from the true book value. Most accounting jurisdictions are based on a general clause that requires the corporate account to give a true picture of the corporate earnings, assets and liabilities. Indeed, when the external audit firms, the board of directors, and the top-managers sign the corporate account they are often required to make an explicit statement saying that they sign the accounts in conviction that they are showing a true picture of the firm's financial situation. Everybody who knows jut a little about auditing also know that the concept of 'true accounts' is a very elastic concept because of the many alternative ways that can be pursued to produce the accounts. It is simply too difficult to define exactly what are the true earnings or assets. Therefore, in order to get somebody convicted for violating the general clause the accounts have to be grossly misleading. The exhibition show that the book values should be overvalued by about 300% or undervalued to about 33% of the true value before it is possible to take legal action. These boundaries are arbitrarily set and should be expected to vary between different types of corporations.

'Creditor fraud': Illegal and litigationable 'pumping' of book value

Firms that make less than ordinary profits have an incentive to hide their problems by pumping up their book values and earnings. Poorly performing firms may in particular be afraid of the creditors’ reaction. For instance, if credits are frozen the firm would almost certainly bankrupt. However, they may also try to hide their true financial situation from suppliers that most likely would start to require payments in advance if they heard of serious financial problems. Furthermore, potential customers could be lost if they heard that it was uncertain that the company would be around to finish or service deliveries. A special but potentially very damaging incidence of value pumping is the situation of substantial ownership by a financial institution of other non-financial corporations. Such ownership constellations are prohibited in most western countries, because a troubled financial institution could abuse its ownership power to order a pumping of book values in order to avoid being unable to fulfill its reserve requirements.

'Tax fraud': Illegal and litigationable 'shrinking' of book value

Every firm has an incentive to understate its earnings and book values, because it can defer tax payments by doing so. This is one of the key reasons that tax accounting often is governed by an entirely different set of rules and conventions than the ordinary public financial account.