Posted by A stock market, like any other market, helps to find the equilibrium of a commodity, in this case stock shares, as quickly as possible. This process is usually called “price discovery”.
Traditionally, price discovery is based on the interactions of buyers and sellers in a marketplace. The publicly quoted share price demonstrates how capital markets value a company, and it’s the basis upon which the company allocates capital towards paying dividends, buying back company shares, compensating employees, paying down debt or reinvesting in the enterprise for future growth.
But today, 3 trends are colliding to distort how markets are pricing companies. The dangers of this distortion, especially at a time of buoyant stock markets, is that company executives and investors use these incorrect valuations as a basis to enter unaffordable M&A transactions and/or over leverage the company. The 3 trends are:
1. Low interest rates
Historically low interest rates, massive stimulus in response to the global pandemic, and the rising threat of inflation are leading to questions on appropriate discount rates to value a company in its entirety – its equity and its debt, including its pension obligations.
Low interest rates are also fueling enormous money flows into private capital, as are lower expected returns from public markets. Private equity investors are sitting on approximately $2.5 trillion in cash, according to Preqin. That is the highest on record and more than double what it was 5 years ago. Looking ahead, venture capital and private equity combined were predicted to more than double their assets from $4.4 trillion at the end of 2020, to $9.1 trillion by 2025.
Capital flows to private equity have been accompanied by a decline in publicly traded companies. According to the Wilshire 5000 Total Market Index, the number of publicly listed U.S. stocks peaked at a record of 7,562 in 1998. At the end 2020, there were fewer than 3,500. This decline means there are fewer public peers for business leaders to value their companies against, and less liquidity for companies as capital drains from the public capital markets.
2. Shift towards passive investing
Another shift occurring across the investor landscape that can affect company value is the trend away from active investing toward passive funds. From 1995 to March 2020, passive funds grew from 3% of equity markets to make up 48% of assets under management in equities as of March 2020, according to a paper by the Boston Fed.
As of 2019, passive funds are estimated to be around $4.3 trillion, and they’re expected to reach parity with active funds with each totaling $13.4 trillion in assets by 2025, according to Price Waterhouse Coopers.
The growth in passive funds can materially improve stock price stability in the markets, reducing volatility in the shareholder register and potentially in the stock price itself, because passive funds strictly track benchmarks, only sell stocks and leave the benchmark, and are therefore considered long-term, permanent capital. These data suggest a shift which should aid in a better price discovery process – more price stability from permanent capital.
However, the shift towards passive investors tips that balance of power toward a small number of dominant investors, which could create additional complexity for companies. For example, the three biggest passive investors by volume – BlackRock, Vanguard, and State Street – own around 20% of the shares of the typical S&P 500. These three funds combined own 18% of Apple shares, 20% of Citigroup, 18% of Bank of America, 19% of JPMorgan Chase, and 19% of Wells Fargo, according to Bloomberg.
In practice, this means these prassive investors wield enormous power – and potentially could find themselves on both sides of an M&A transaction, not only unveiling conflicts that have to be cleared but also potentially impacting the price of a deal. Specifically, the same passive investors would be important shareholders and voters on both sides of a merger between 2 companies. When the vote comes on whether to accept a bid, investors on both sides of the trade might be willing to accept a lower price than those who solely own shares in the company being sold.
3. Cryptocurrency and other global financial innovations
Fundamental changes in the global financial architecture – whether the rise of cryptocurrency or the threat of China’s efforts to unseat the U.S. dollar as a reserve currency – could also materially affect the price discovery of a company depending on how it is exposed and positioned.
With respect to cryptocurrencies, issues of volatility and speed lead skeptics to wary of its effects. With customers and suppliers adaptation to their use, companies should consider the effects of placing cryptocurrencies on their balance sheet – and the potential impact on company valuation. For instance, Bitcoin’s volatility would make it harder to calculate the true value of a company at any given point. Bitcoin’s three-month realized volatility, or actual price moves, is 87% versus 16% for gold according to a February 2021 report by JPMorgan.
Meanwhile China is now the largest trading partner, foreign direct investors and lender to numerous developed and developing countries around the world. It’s also the largest foreign lender to the U.S. government. Through expansive cross border efforts, such as the Regional Comprehensive Economic Partnership (RCEP) trade agreement, the Belt-and-Road Initiative and its use of derivatives in trading contracts, China is stamping its imprimatur on the globe. But perhaps most crucially China is backing its own digital currency, a virtual yuan. Although not a peer-to-peer cryptocurrency, could challenge both Bitcoin and the U.S. own attempts at a digital dollar.
Corporations will have to weigh up the risks and benefits of crypto and digital currencies and decide whether to hold them as assets and liabilities on the company balance sheet; a decision that will affect the company’s value.
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