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

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?

• What it sounds like is that at a more fundamental level, you want to capture the difference between 'value' and 'current value'. In market capitalisation terms, this could be similar to something like book value vs market capitalisation. – ifly6 Mar 4 at 19:28
• Actually, what I want is to be an investor and invest in plans: give money to the plans and into the company and not into the supply of stock / market. – Julius Baer Mar 5 at 7:16

2 Answers

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.

• Thank you. I updated the question. It needs further editing. This is becoming more like a discussion than Q&A. Please remove your emphasis on principal agents, management: my question is the other way around, with emphasis on the "disconnect". – Julius Baer Mar 5 at 7:13
• Hey Julius, this is really unfair. Your question is drastically different now. If you think that my previous answer clarified your previous question but you have further questions, the correct thing to do is to mark my answer as correct. You can later add another question referencing this one and asking the new question you have. – Regio Mar 5 at 17:20
• That way, everyone can benefit from your original question, I can benefit from the time and effort I put into answering, and you can keep learning using this platform. If possible, please revert to your original question and do the appropriate. – Regio Mar 5 at 17:21
• I understand, and normally it would be OK. I'm sorry but the original question had an ellipsis in the title and the request to 'feel free to edit the question.' The multiple questions that I allude to in my introduction already provide the relevance of management and credibility in their answers. I will add links to those. But this question is really not about the relevance of the stock price to the company, quite the contrary. – Julius Baer Mar 6 at 15:33
• good luck, then :) – Regio Mar 7 at 17:38

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.