Market factors that create valuation disparities

While there may be no clear and objective measure of the significance of apparent valuation discrepancies, you should understand all of the factors that create a discrepancy before using it as a basis for any investment strategy.

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The efficient market hypothesis would seem to deny the possibility that meaningful valuation disparities could exist in a free and transparent investment market. The hypothesis states that material information quickly becomes widely dispersed. As a result, it can give no one more than a fleeting potential advantage. Therefore, since all participants have the same access to actionable information, it can be reasonably presumed that the market generally reaches effective consensus quickly on a valuation. It can also be presumed that the market maintains its consensus indefinitely, until new information emerges to change it.

The efficient market hypothesis rests on some unspoken assumptions. One assumption is that all decisions in the market take full account of information predictably and consistently. Another is that there is, in fact, one single market in which all factors are considered uniformly. And a third is that all pricing decisions in the market are completely rational. If any of these assumptions were to break down, then market valuations could become inconsistent, and the door to structural disparities in valuation could open.

How the options market can value shares

In the normal course of business, an investor can use a company's share price to estimate what an option for that share could be worth. The actual arithmetic of an option price estimate is extremely complex, better left to a customized computer spreadsheet or an online calculator such as the one offered by the Options Industry Council. But the framework for the calculation suggests options prices can be an alternative means for valuing shares.

The theoretical basis for options valuation was established by economists Fischer Black, Myron Scholes, and Robert Merton decades ago. Scholes and Merton earned the Nobel Memorial Award in Economic Science for their efforts in 1997 (Black was cited posthumously in the award). Their pioneering work demonstrated that a stock option's theoretical market value at any given time depends on:

  • Market price of the underlying share at that time
  • Price at which the option can be exercised
  • Length of time the option will be in force
  • Expected volatility of the underlying share price
  • Expected dividend yield of the shares
  • Interest rate that an investor can earn on the least-risky fixed income alternative

Typical calculators use equations in which the variables listed above are combined mathematically to produce an option value derived from the observed stock price. But if one were to take an option value as a given number to replace the stock value, the other data points could be combined mathematically to produce an estimated stock value derived from the observed option price.

In normal market conditions, the implied stock price on the options market should be consistent with the observed stock price on the stock market. But variations in interest rates and in market volatility can introduce significant fluctuations to the options price, even though the same factors may have little or no immediate influence on the underlying share price.

Single stock futures are a second alternative source of value

For many stocks, it is possible to trade the promise of a future delivery of shares, creating an estimate of what those shares might be worth at some future date rather than today. Typically, the important elements in valuing a futures delivery contract are current price, dividend yield, and the return on the risk-free investment alternative. Although the arithmetic for estimating the value of the futures delivery contract may be simpler than that of an options contract, it may still be difficult to perform manually. From a theoretical perspective it would be possible to use the market value of a futures contract to estimate an implied current share price. But keep in mind that futures pricing may give greater weight to changes in interest rates and dividend returns.

The potential price of randomness

It has been argued that any market-derived value of any financial instrument could change unpredictably, at least in the short term. John Maynard Keynes warned of the influence of "animal spirits" over markets, and said it could be foolish to "… attach great weight to matters which are very uncertain."1 Burton Malkiel argued that share prices follow an essentially arbitrary path on a day-to-day basis.2

Experts such as these maintain that observed variance in valuation might be the product of random chance and individual irrationality. They thus provide little actionable insight because conditions could soon change. While there may be no clear and objective measure of the significance of apparent valuation discrepancies, you should understand all of the factors that create a discrepancy before using it as a basis for any investment strategy.

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