Weighing Machine, Voting Machine

The influence of what we call analytical factors over the market price is both partial and indirect – partial because it frequently competes with purely speculative factors which influence the price in the opposite direction; and indirect, because it acts through the intermediary of people’s sentiments and decisions. In other words, the market is not a weighing machine, on which the value of each issue is recorded by an exact and impersonal mechanism, in accordance with its specific qualities. Rather we should say that the market is a voting machine, whereon countless individuals register choices which are the product partly of reason and partly of emotion. Hence the prices of common stocks are not carefully thought out computations, but the resultants of a welter of human reactions.

– Benjamin Graham and David Dodd, Security Analysis, 1934

Two aspects of the financial markets operate simultaneously. Emphatically, they do not operate alternately, but simultaneously. One aspect is driven entirely by arithmetic. Every security is a claim to some long-term stream of cash flows that will be delivered to the holder, or series of holders, over time. The future cash flows and the current price are linked by a long-term rate of return. You can think of the long-term return as the slope between the current price and the future payments. Pure arithmetic. Given any set of future cash flows, the lower the price an investor pays, the higher the long-term return an investor can expect.

Nothing ensures that the price is reasonable, but reasonable or not, the moment you know both the cash flows and the current price, you also know the long-term return. Even if investors pay $150 today for an IOU that will deliver just $100 a decade from today, the arithmetic still holds – in this case, the investor can expect a 10-year return of ($100/$150)^(1/10)-1 = -4% annually. Investors may be insane to pay that price, but the math is just math.

Log price and expected return of simple 10-year IOU

The arithmetic that links current price, future cash flows, and long-term return is equally true for stocks as it is for bonds. The main difference is that the cash flows for stocks are typically longer-term, and some amount of estimation is required. Still, given an estimate of future cash flows, the math is the same.