Monday, April 28, 2014

A Fable on Stock Market Valuation

Why valuation is a lousy measure.

King Midas gave up the gold thing, and bought all the outstanding float of $KMID.  Midas owned 1,000,000 shares of the stock, and on the day he bought the last share, he paid $100.  Therefore, the closing price of the stock gave him a market cap of $100 million.  That’s one hundred million dollars.

Now Little Johnny tended the King’s gardens and prevailed upon him to sell him a share of $KMID.  Believing it was undervalued he offered the King $110 for that share.  The King was an evil man, so happily took the money at the bid.  He was amazed to find out his value in the company had risen to $10,999,890.  And he had 110 bucks cash to show for it. 

When Johnny’s mother found out that he had blown the family grocery money, he forced him to return to Midas to sell the stock back.  The evil Midas agreed, but at the price of $105.  With no alternative, Johnny took the price, poorer but wiser. 

King Midas had all his stock back, $5 in his pocket, and a new market valuation of $10,500,000.  The stock caught the attention of the Wall Street pundits and trend followers. But, of course nothing about the company or the stock really changed.  

Farfetched?   I suppose.  It would take a lot of dumb, evil people make something like this happen in the real stock market.

Oh, yeah.   Think about that the next time you invest in a stock simply because the price changes.  

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