How Central Banks Stoke Stock Prices
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Reading through Security Analysis, the roadmap for investing first published in 1934 by Benjamin Graham and David L. Dodd, I learned something quite interesting: The basis of stock valuation had changed quite drastically in the period between 1927 and 1929. The stock buying public “departed more and more from the factual approach and technique of security analysis and concerned itself increasingly with the elements of potentiality and prophecy”, write Graham and Dodd.1
What they mean is that in the pre-WWI world, stocks were typically valued on the basis of a three-part concept: (i) a decent track record of firms’ dividend returns, (ii) a stable and satisfactory earnings record, and (iii) a strong balance sheet, with sufficient backing by tangible assets. The “New-Era” theory of stock valuation reads, summarized in one sentence, as follows: “The value of a common stock depends entirely upon what it will earn in the future.”
Current dividends should only have a slight impact upon a stock’s valuation, and as firms’ asset values did not have an apparent relationship with their earning power, asset values were said to be devoid of importance when it comes to calculating a stock’s “fair price.” A firm’s earnings record was only relevant to the extent that it might indicate what changes in a firm’s future earnings were likely to be expected. In other words, the New-Era theory of stock valuation was quite a break compared to the valuation technique employed in the past.
A Sea Change in Pricing Stocks
According to Graham and Dodd, there were two significant causes why such a change in the approach to stock valuation occurred. First, accounting data of a firm’s past proved to be increasingly unreliable as a guide for making wise investment decisions. The reason for this was rapid changes in demand structures and product and process technologies. Second, the expectation of future rewards became increasingly attractive to many investors, in fact, “irresistibly alluring.”
The New-Era theory of stock valuation, which people followed in the hot phase of the 1927-1929 stock market rally, turned out to suffer from two weaknesses, according to Graham and Dodd. First, it encouraged people to speculate heavily: stock prices were driven by expected future profits, detached from “the facts of the established past.” Second, established standards of valuation were thrown overboard. Any prevalent valuation level could easily be interpreted to be the new standard of valuation.
“Fantastic reasoning” fueled the stock market bubble because people did not have to concern themselves with the question of the “fair price” of a stock any longer. With the New-Era theory of valuation, people would buy “good” stocks, regardless of their price, in the hope of having found a get-rich-scheme, given that there was the possibility of the new level of standard valuation in the future being higher than the level of standard valuation seen in the past. We all know how tragic this doctrine turned out to be.
Then, the New-Era theory of valuation developed into a somewhat more elaborate doctrine. In his book The Theory of Investment Value, published in 1937, John Burr Williams, presented the “dividend discount model.” It says that the value of a firm’s stock – and thus its “fair” price – is equal to the present value of all its future dividends. Williams’ dividend discount model has become the standard valuation formula for stocks. However, it stands in the tradition of the New-Era theory of valuation doctrine.
The dividend discount model caters to speculative frenzies. For instance, it might justify a high price of a firm’s stock even if the firm has not delivered any dividend so far — just by referring to a firm’s earnings power that is hopefully going to unfold in the future. At the same time, however, the dividend discount model clearly rests on a sound economic idea. It epitomizes a category of human action, namely time preference: One US dollar today is — and logically so — valued more than a buck to be received in one year’s time.
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