This is a continuation of the series of posts on stock pricing. The first post of the series is here:
Today I will talk about the effect if the returns of other investment choices on stock pricing, which I call Comparative Factors. As stated in the last post, the future returns of stocks are not foregone conclusions. Many things can happen either at the company itself (for example, fraud or missteps by management). The industry as a whole could suffer a setback. At times, the entire economy can falter, dragging all stocks with it.
Because of these risks, the price of a stock is set such that the return will be greater than it would be if the exact return (which is basically the future earnings divided by the share price) of the stocks was known ahead of time. The price of the stock will follow the fundamental factors – earnings and dividends, such that the price will rise if a company increases earnings or raises the dividend, but it will always remain low enough such that the investor will earn more than she could if invested in some security with a more predictable return. This discount in the price, which is called the risk premium, is the extra reward that is necessary for investors to take on the additional risk.
The amount of this risk premium, however, is not set in a vacuum. The risk of a given investment will always be compared with those of other investments. The more risky the investment, the greater the risk premium. (Note that sometimes more risky investments are sold to unsuspecting investors as low risk investments, usually through late-night commercials, offers in the mail, and the like. Keep in mind that the level of return is always proportional to the level of risk. If someone ever says that great returns can be had for low risk, run, don’t walk, away.)
For example, bank account typically pay returns that are 1-2% less than the inflation rate (yes, by keeping money in savings, 1-2% of your money will be eroded each year). Investment garde bonds (bonds in companies that most analysts expect to be able to repay the loan) typically pay a few percentage points more than bank accounts. Junk bonds – bonds in companies that are more likely to default on the bonds) will trade in the range where they pay several percentage points more than the investment grade bonds. Note that companies that have shaky balance sheets when the bonds are issued will need to offer greater interest rates initially to get people to buy the bonds. If a company gets into trouble after bonds are issued, the price fo the bond will drop, causing the effective interest rate to increase. The longer the amount of time until the bond will mature and the loan will be paid back, the higher the interest rate will be.
Common stocks will typically trade such that their return (based on future earnings and dividends) will lie somewhere between investment grade bonds to and beyond the return for junk bonds. The return of the stock will depend on the risk involved. Strong, established companies with predictable earnings will typically have a smaller risk premium than young, start-up companies that have not yet established market dominance. Buying the blue chip stocks will typically result in smaller fluctuations in account value, but the returns will be reduced over those of the smaller companies over time. For this reason, better returns can typically be had in the small and mid-sized companies than in the large caps. There are times, however, when investors are fearful about the economy when large-caps will do better than small-caps.
In the next post I go into what I call the emotion factors. https://smallivy.wordpress.com/2010/12/10/how-stocks-are-priced-part-4-emotion-factors/
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Disclaimer: This blog is not meant to give financial planning advice, it gives information on a specific investment strategy and picking stocks. It is not a solicitation to buy or sell stocks or any security. In addition the writer of this blog is not an accountant and writings should not be taken as tax advice which should be left to a CPA. Financial planning advice should be sought from a certified financial planner, which the author is not. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.