WHY DO STOCK PRICES DEVIATE FROM BUSINESS VALUATIONS

Stock prices are based on the beliefs of the market and, in turn, affect the beliefs of the market If the market believes that a stock is overpriced, then the price will decline until such beliefs are no longer expressed Such beliefs are based on the fundamentals and the perceptions of investors The fundamentals are the facts about a business and its prospects that are publicly available The perceptions are the opinions of investors about the facts, about the current economic environment and about what will happen next This perception is often influenced by the price of the security For example, if the price of a stock is rising, then more investors will tend to believe that the fundamentals are good This will cause the price to continue to rise The Market€™s Beliefs The market€™s belief about a security may be based on the fundamentals or on the perceptions of the investors The following two examples illustrate how these beliefs affect stock prices Example 1: Demand for a Product Increases Suppose that one of your companies has invented a new product that is a substitute for an existing product The new product is superior in every way to the existing product and will capture most of the market Now you must decide what to do with the existing product You could discontinue it, but the market for it is still quite large, and there is no reason to believe that it will be declining soon Instead, you decide to sell the product at a lower price than the new product, even though it is identical to the new product You will continue to sell the existing product until you have captured most of the market, after which you will discontinue it The new product will have the following effects on the market: (1) it will cause the demand for the existing product to fall sharply, (2) the price of the existing product will decline sharply and (3) the demand for the new product will rise sharply The demand for the new product will rise sharply because it is superior to the existing product The price of the new product will also rise because of the demand for it