How can I estimate the disconnect between book value and market capitalisation?

Question

There are several questions on Stack Exchange as to what difference the stock price makes to a company after its IPO. Surely, management cares, it is important to be credible to trading partners, etc.

However, with passive investment being about 50%(?) of the stock market and at the same time the stock price not having a direct influence on the balance sheet, external shocks like the coronavirus won't be blamed on management. To some extent the stock price is just determined by people talking up (sellers) or down (buyers) the stock price. Perhaps short sellers talking it down and long holders talking it up.

How do I make a quantitative indicator that describes the disconnect between the market capitalisation and the book value? What options are there?

Sub 1: When it is said there is an asset price bubble, it usually means stock prices (or RE). Are the assets that actually are on companies' balance sheets also inflated?

I thought it interesting to be an investor: to invest in companies that have worthwhile plans. In reality however, I seem to be buying stock (secondary market) from previous stockholders (primary market). The problem is that the primary market largely ceases to exist after the IPO. You might say that stock buybacks and re-emissions are primary market operations, so I guess my question is focused on the difference between those two.

Sub 2: Why are secondary market participants called investors?

Sub 3: Would it be possible to keep the primary market alive by changing the law?

Answer 1

The context of the question is analysis of the plans of the company, the market price, and the book value.

Primary investors provide cash or other resources to the company in exchange for original debt or equity claims against the assets of the company. The company is expected to purchase assets with the cash as it executes the business plan. Secondary investors purchase the debt or equity claims from a primary investor so the company does not get any cash from these secondary transactions. The question is how to estimate the disconnect between market capitalization and book value.

Understanding Price-to-Book Ratio:

https://www.thebalance.com/fundamental-analysis-understanding-price-to-book-ratio-3140794

The calculation of book value:

(Assets - Liabilities)

Ongoing, financially-sound companies will always trade for more than their book value because investors price the stock based, in part, on their anticipation of the firm's future growth.

The Affordable Growth Rate (AGR) is a formula appearing in the book 101 Business Ratios by Sheldon Gates. According to Gates the formula was used by Hewlett Packard. This article describes AGR

https://www.inc.com/magazine/19861201/9293.html

The AGR is a growth strategy based on two assumptions. The first is that your sales can grow only as fast as your assets. If yours is like most firms, for example, you can't increase your sales by 30% unless you increase your receivables, your inventories, and your fixed assets by about 30% as well. The second assumption is that your firm has a target debt-to-equity ratio and that your lenders are willing to continue to extend credit at that ratio. This assumption implies that as your equity grows, debt can grow at the same rate, allowing you to maintain a constant debt-to-equity ratio.

The sources of cash to grow assets, and therefore sustain sales growth, is debt, equity, and retained earnings. When a firm is taking venture risk the future cash flows in the form of retained earnings are not expected to be sufficient to cover the growth of assets in support of sales growth. When a firm is throwing off cash it has high retained earnings or profit that can also be used to pay dividends. There is another book called The Cash Flow Problem Solver, by Bryan E. Milling, which describes in detail how a company can grow too fast and cause a cash flow crisis that results in bankruptcy.

There is no direct link between market capitalization and book value because market capitalization is the last sale of one or more shares of stock in a secondary market transaction based on the desire of the buyer to own shares at that price and the seller to own cash rather than shares at that price. The market capitalization contains a liquidity premium if the shares are relatively easy to buy and sell on the secondary market and a growth or discount factor, based on expected future events, so there is a disconnect between market capitalization and book value.

If the firm is expected to remain a going concern and grow assets, sales, and profits in the future, especially after reaching cash flow break-even following new injections of debt or equity, and if it can grow from internal finance of retained earnings from operations after getting past cash flow break-even, then there is a premium in the share price above book value. There is no particular formula for evaluating the plans, asset position, debt and equity claims of a company, and there is no particular formula to forecast future sales, profits, and retained earnings, and there is no particular way to put a premium or discount factor on the share position, so there is no particular way to link market capitalization to book value.

Answer 2

You are right that the stock price affects directly the shareholders. In contrast, the managers of a company (the CEO, etc) are not necessarily affected by the stock price. However, their actions have a very important impact on the stock price.

The conflict of interest between the shareholders and the managers of a company is the classic problem of "principal-agent", the principals are the shareholders (more specifically the board of directors), and the agents are the CEO's, CFO's, etc. Because the principals understand the conflict of interest, most agents are paid in stocks of the company or adjust salaries based on the performance of the stock. That way the agents have a more direct incentive to drive the value of the stock up. So this partially answers your question "what difference the stock price makes to a company after its IPO".

Your second point has two parts: Whether shocks on the stock price affect management even if they cannot be blamed for it and the disconnect between "chatter and business".

About the first part, you are right. The CEO will probably not have reputational costs if the company loses value due to Covid19. However, their income will still decrease if they are paid in stock.

Your second point about the disconnect between chatter and business is the classic difference between the "fundamental value" of stock -- the "business" part of it -- and its market value which includes the fundamental value and any "chatter". The fundamental value is a theoretical benchmark of what the stock price should be given the assets of the company, the expected growth, etc. In contrast, the market value is what we actually observe in the data.

Depending on the company, the non-fundamental value of the company can be attributed to speculation, pessimism in the markets, outright deceive of the managers in their financial statements, a hostile takeover, etc, etc, etc.

It is actually quite hard to estimate how much of the market value is fundamental value and how much is "chatter", but there are theoretical models (like Tobin's Q or others) that help you estimate the fundamental value of a company.

Therefore, it is hard to come up with a good indicator that can be applied in general. You can see this, for example, by realizing how hard it is to know when there is a bubble in the financial market. A bubble is simply a situation where market prices are way higher than their fundamental value. Probably Tobin's Q is still a good starting point.

Answer 3

sub1: When it is said there is an asset price bubble, it usually means stock prices (or RE). I wonder if the assets that actually are on companies balance sheets are also inflated?

They are, banks for example hold so called Tier2 and Tier3 assets on their balance sheets that are essentially equity or debt of other companies. In a March 12th type of collapse, those assets also immediately have to be revalued as market prices are set. Oil fields may feature as assets on oil company books. Sometimes asset prices are calculated based on the cash flow they generate or even are expected to generate in the future.

sub2: Why are secondary market participants called investors?

They could be called speculators. However, if you do call the initial early stage investors investors, then the secondary market participants are essentially replacing those initial investors: they are simply different people or different investors in name. It is true nonetheless that many such secondary market participants praise the stock they hold when they could reasonably be assumed to be interested in a higher price. And, secondary market participants have a different role than early stage investors.

sub3: Would it be possible to keep the primary market alive by changing the law?

You could say, only the company is allowed to buy and sell stock to and from an investor and no secondary market would be allowed. Chia has something like that, but it is circumvented by ADR's for example. The primary market also stays open with buybacks/splits/rights issues, credit and debt.

As for my main question, there are at least some well-know indicators like Q (mentioned here), and a whole list of ratios.