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front-page exposure to three million readers and potential new investors. The stock price multiplied from its closing price of $12 on Friday to open at $84 on Monday. Is this a rational reaction Emotions often play a large role in the stock market. Some market players may translate the information that they receive into overly optimistic or pessimistic influences on a company s expected future cash flows. A stock s price may be bid up for a time to an unrealistically high level, or it may be driven down to an unbelievably low bargain opportunity. Some info may affect an industry as a whole. For example, if Dell Computer Corporation unexpectedly lowers its revenue projections for the year, its stock price most likely will decline, perhaps significantly. That announcement may also negatively affect the stock market price of other computer manufacturers. Logically, investors will conclude that the industry forces that are affecting Dell may also adversely affect IBM and Hewlett-Packard. The announcement may also lower the stock prices of Microsoft, which sells software that s bundled into Dell computers, and Intel, which sells microprocessors to Dell. Some information may affect the stock market as a whole. For example, political and labor stability, decreasing income taxes, low inflation, and small equity risk premiums (associated with stable interest rates and cost of capital) are major bonuses for the vast majority of stocks. Conversely, labor and political unrest, higher inflation, increased income taxes, and a greater perceived equity risk premium (associated with higher interest rates and cost of capital) are huge downers for stocks in general. Equity risk premiums increased greatly around the 9/11 terrorist attacks and again during the corporate governance scandals of Enron and WorldCom. With all this info bombarding investors and causing constant reevaluations, market prices seesaw quite a bit. Does a stock s intrinsic value change as frequently as and in unison with its price The evidence is to the contrary. A lot of academic research has been conducted regarding the movement of stock prices and the noise associated with that movement.6 Because of overly optimistic or pessimistic views in the market, a stock s price may diverge significantly and for a long period of time from a stock s intrinsic value. That happened during the inflating of the Internet/telecom/high-tech bubble. Over time, however, stock value and stock price should converge on a regular basis.
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STREETSMART GUIDE TO VALUING A STOCK
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Stock Value, Stock Price, and Analyst Recommendations
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Intrinsic value, like beauty, is somewhat in the eye of the beholder and is influenced by the valuation model used and the assumptions made in the analysis. Wall Street (and non-Wall Street, for that matter) analysts incorporate their own spin to the models that they use to calculate a stock s value. An analyst s estimate of intrinsic value will be based upon the current fundamentals (historic revenue growth, net operating profit margins, etc.) associated with the stock, and more importantly, upon analyst s beliefs about the future development of those fundamentals. Some of the assumptions, such as expected growth rates, may be overly optimistic and may result in values that are impossible to justify in relation to the underlying operations of the company. An analyst who believes that a stock is priced below its intrinsic value would recommend a purchase of the stock. On the flip side an analyst, fearing retribution from the corporate client, may be more reticent to recommend a sale of a stock that is priced above its intrinsic value. An analyst that gives a stock a sell recommendation has a much more difficult time in getting information from that company in the future. Also, sale recommendations tend to strain relationships between the company and the firm s investment banking department, which may be trying to get a lucrative piece of business from the company, making that analyst persona-non-grata in the investment bank s corporate dining room. Instead of a sell recommendation, an analyst calls an overpriced stock a fully valued stock or a long-term hold situation. Be cautious when hearing those terms. Since the bursting of the high-tech bubble, stock analysts and conflicts of interest have been the focus of much public attention. The bullish stock reports and bearish internal emails of Henry Blodget, the former Internet stock analyst of Merrill Lynch, have caused Merrill embarrassment and were a large factor in the $100 million settlement in late 2002 of an action brought by the New York State Attorney General, Elliott Spitzer. Blodget has been banned from the securities industry and assessed a fine of several million dollars. In August 2002, Jack Grubman, the former telecom analyst at Salomon Smith Barney, resigned amidst SEC investigations alleging that he upgraded or main-
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