One Man’s Over-Simplified View of the Stock Market

It’s a bit troubling to watch investments freefall like they did last week.  It seems like everyone is expecting the government to be able to pull some sort of brake to stop the freefall, but in actuality there’s very little that the government can do that will have an immediate effect on the stock market. 

In my mind, I have over-simplified the pricing of stocks to this:

[Stock Price] = α[intrinsic value] x ß[extrinsic value multiplier]

Every stock valuation equation that I’ve ever seen ends up being some derivative of the above, where the intrinsic value is pretty constant and is related to the company’s holdings and it’s ability to generate consistent profits. The extrinsic value is subjective and can vary widely and can be seen more as a measure of the confidence that the pubic has in a company.

Over the last few weeks, the real inherent value of the companies that make of the DJIA, the S&P, and the market as a whole has not really changed.  What has changed it the perception of the extrinsic value, i.e. the potential for continued growth in value and earnings, and the ability of the company to weather a slump in the economy.

Now the interesting dilemma facing those in power right now is that everyone is screaming that they need to fix ß when the only way to fix ß is to set up a system that protects α, and that gives confidence to the public that you will continue to support α in the future.

As much as I am instinctively against the idea of the current bailout bill, there are some facets of it that make sense, and I think we’ll start seeing some progress in the next few weeks.  The bailout bills’ main focus is to break-up the gridlock that we currently have in the short-term liquidity markets.  This protects α by helping companies that have real value to avoid folding simply because they can’t get the short-term loans they need in order to operate. This helps us avoid a real reduction in the intrinsic value of companies, and in the long run that should be the focus of every leader who is currently attempting to help solve this crisis.

Disclaimer:  This post is not financial advice, I may have a business degree but I don’t claim to have any special expertise in economics.  I just had a few ideas I wanted to spout off.