How Investment Bankers Determine When the Stock Market is Distorted - dummies

How Investment Bankers Determine When the Stock Market is Distorted

By Matt Krantz, Robert R. Johnson

Examining stock prices and other market prices is valuable, because the data is based on actual dollars and shares trading hands. But investment bankers need to be aware of the fact that oftentimes stock prices don’t exactly reflect reality.

Sometimes even sophisticated investors get so enamored with a stock, an industry, or the entire market that they chase the stock to astronomical heights. Investment bankers need to be aware of periods of temporary insanity in the markets — they need to be the sober parties even when there’s a stock mania brewing. The market is usually effective pricing stocks over the long run.

But investment bankers may get a tip that market prices aren’t reflecting reality when

  • Valuations get stretched. Valuation ratios, such as the P/E and price-to-book can be a reality check for investors during times of market insanity. When investment bankers see the P/Es of certain stocks or industries blow away historical averages, it can be a clue that something strange is afoot.

    Stocks can be overvalued or undervalued for a very long time. Just because a stock has an elevated P/E doesn’t guarantee that the P/E will revert to the mean anytime soon. But an elevated P/E is a sign that investment bankers need to pay attention to.

  • Insiders start selling their stock. There are two types of activities often referred to as insider trading: the legal kind and the illegal kind. It’s illegal for insiders of companies, such as employees, to use material and non-public information to trade for personal gain.

    But there’s a legal type of insider trading, which is simply when company executives buy or sell shares of the company’s stock. When CEOs buy company stock, some investors see it as a sign the stock is undervalued. Similarly, when investors see lots of insiders dumping stock, that’s a sign the stock may be overvalued.

    Investment bankers know insiders must reveal their trades in regulatory filings called the Form 4. You can access Form 4 documents from the SEC’s website.

    Sometimes, insider moves can be very prescient. For instance, an early investor in Facebook and board member, Peter Thiel, filed a Form 4 on May 22, 2012. In this filing, Thiel disclosed he was selling more than 10 million shares of Facebook stock at $37.58. Talk about perfect timing. Facebook’s shares began to decline in September 2012, hitting a low of $17.55.

    But other times, CEOs just sell to raise money to buy a house or put their kids through college. They also may be selling to diversify their portfolios as they typically have a lot of eggs in the company basket. (They’re people too, you know.) These types of insider stock sales aren’t very indicative of the future direction of the stock.

  • Stocks start gaining in parabolic moves higher. Sometimes the public gets so enamored with a company’s stock or an entire industry that the price gets pushed to ridiculous heights. Armed with tools such as discounted cash flow analysis, investment bankers can dispassionately estimate how much a stock is worth based on certain assumptions, and realize when market values are much higher.

    Some investors push shares of popular stocks well above the actual value of the company. Apple was a classic example. In 2012, the stock was one of the most popular in many investors’ portfolios. But reality soon caught up, and the stock fell about 50 percent, to below $400 a share.