Seeking invariants from chaos...

The Uncertainty Principle of Fair Stock Prices & Valuation Bands

We believe that it is not possible to determine a single fair price for a stock, because of

  • the extreme sensitivities of the stock valuation to the necessary underlying assumptions such as long term growth rates, risk premiums, and interest rates (in this regard, one can think of stocks as infinite-duration bonds with uncertain yields), and

  • the inherent uncertainties associated with these underlying assumptions. 

Consequently, instead of a singe fair price for a stock, the best anyone can do is to determine a "valuation band" which is a range of possible fair prices. Very importantly, the valuation band is frequently very wide -- as much as 10 times difference between the higher and lower bounds for stocks going through substantial uncertainties. Lacking adequate appreciation of this fact can make the discussion of whether a stock is over- or under- valued fruitless.

Stock prices vary in and out of valuation bands,  driven by three factors:

  1. Rational Factor: events and new information which make it necessary to change the underlying assumptions, which in turn change the valuation band.

  2. Psychological Factor: the changes in perceptions of the underlying assumptions drive the stock prices to vary within the valuation band. Given the same set of fundamentals, investors perceptions can vary widely depending on their psychological states ranging from fear, desperate, cautions, hopeful, optimistic and euphoric.

  3. Momentum Factor: technical traders and trend-followers also drive the stock prices, sometimes making stock prices reaching new equilibriums more quickly, other times helping driving stock prices to extremes outside of the valuation bands.

Previous         Next