Understanding the differences between market and business value and how they impact active and passive solutions highlights some of the unintended consequences that can arise from a passive-only approach to investing.
The current trading price of a stock, its market value, may or may not be a reflection of the underlying business value of the company it represents. Generally speaking, business value is the discounted value of future cash flows — it is a reflection of expectations for the fundamentals and financial position of the underlying company. Market value simply reflects the current trading price of a company's stock, largely based on supply and demand.
Over time, stock prices tend to track the earnings of the businesses they represent
Over the last five years, earnings growth has lagged market returns, leading to a significant divergence. Looking back over the last 25 years, however, we see that earnings growth and market returns are fairly similar despite such short-term divergences.
Business value reflects what an informed buyer would pay
An informed buyer will look at the unique qualities of the company's market, as well as the size of the company's market, its sector, stage of development, growth potential, customer base and competitor landscape.
Market value is influenced by sentiments outside of business fundamentals
The market value of a stock is not determined by a company's economic prospects; it is simply the price that an investor is currently willing to pay for the stock in the market. It is subject to the supply of shares and the demand for those shares.
Market value must eventually reflect business value
Although events such as the U.S. presidential election are catalysts for a change in the market, markets are forward looking. Much like campaign promises, time will either confirm current market valuations or show them to be too high or too low.
Chief Investment Officer
Asset Management ,England
Aura Solution Company Limited