Fundamentals of share

One of the side effects of my working experience at Yahoo was that I got stock options from the company and for a couple of years I was somehow “interested” in the share development.

The Yahoo share started at 1,4$, at its peak  was worth bit more than 100$, now it’s down to 14$. Which price was the right one?

The economist call the stock market a “random walk with a trend”, meaning that rational people would buy shares today if it was obvious that they would go up tomorrow and sell if it was obvious that they would fall. But this means that any forecast will be wrong: share will rise today instead because people will buy them. In fact, rational investors should be able to second-guess any predictable movements  but that means there won’t any predictable share movements at all, all should be sucked out of the stock market very quickly because all trends will be anticipated. The only thing left is unpredictable news, as a result the market should fluctuate completely at random.

More correctly, on average edge up as the months go past so that it’s competitive compared with other potential investments. Agile, informed and experienced investors will be a bit better than the rest of us, but not by much.

So, what’s this tiny edge over?

First, a share is a claim on the future profit of a company.
Let’s say Yahoo had only 100 shares; if I own one, I have a right to 1% of Yahoo’s profits for as long as I hold the share. If they makes 100K $ per year, then I get 1000$ per year, forever.
If I put 10K $ in a savings account earning 10%interest (!), that will also get me 1000 $ per year.So one share in Yahoo would be like 10K $ in a savings account at 10%.
Interest rates at 5% would make the Yahoo shares twice as attractive (this is why the stock market rise when when interest rates are expected to fall and viceversa).

Yahoo shares were valued at 35$ in October of 2004 and earned 18 cents per share in 2003. But with long-term interest rates in USA of about 4%, it was needed only 4.5$ in a savings account to earn 18 cents a year.

The share should have been trading at 4.5$, not 35$.
Something else justified that price and was the future, specifically Yahoo’s future profitability.

That suggest that investors in Yahoo didn’t expect long-term profits of 18 cents a share, but something much higher; they were clearly expecting earnings per share to rise to $1.40 and beyond to compensate for their risk.
To do this, Yahoo profits would have to rise from $238 million to $1.8 billion a year.

This is all based on fundamentals: in the long run the share price reflects the profit of a real company. But speculations is not based on long term or fundamentals.

For example, if you look back at the past share performance, specifically to the “price/earning (P/E)  ratio“. This ratio should not change over time (as profits grow with share price) and stays usually around 16 (this was the average value in US between 1900 and 2005), becoming suspicious when the P/E is over 30.

So, back to Yahoo share. It had a P/E ratio of 1760 and a share price around 10$ on June 2001. People were clearly expecting it to increase enormously its profit. This is very common for high technology industries. The internet was expected to be a changing game technology, even more than the railroad introduction.

Now the Yahoo share is around $15 and the P/E ratio is around 1370. In these years the profits per share remained very very low and the very large earnings failed to materialise.
As conclusion, I did not earn anything from my stock options … maybe will need more time or maybe it’s Yahoo’s fault at the end.

This is of course just the tip of the iceberg, there is so much more to discover.

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