Given it’s a Sunday and Tesla share price is at new highs, I thought it worth elaborating on my prior post and explaining more about my views of what a share price actually is and what needs to happen to drive a share price on to a new level.
I generally find theory, papers and studies in finance are of a far lower quality than those I read in Science or Machine Learning. Nearly always I can almost immediately find absurd assumptions or failure to account for or isolate key variables which make most of the conclusions largely meaningless. In particular I find many of these papers start with the ridiculous assumption that the efficient market hypothesis is correct and this leads them to make big mistakes when setting up their analysis.
Even outside of the financial academic community and their efficient market dream world, I find very few people actually working in financial markets ever take a moment to think from first principles what is actually happening and what terms in finance actually mean.
For example many Short Investors and market makers seem to have never considered what shorting actually is. In my previous post I talked about this process and described Shorts creating new synthetic shares when they short a stock, but that is a term I made up because I don’t even know if finance has a word for it.
Similarly, few people in finance seem to have actually thought about what a Share Price actually is. And I can’t even find a reasonable answer for it when googling.
Wikipedia’s first sentence includes the obviously false: “In layman's terms, the stock price is the highest amount someone is willing to pay for the stock, or the lowest amount that it can be bought for.” Yes it is the lowest amount it can currently be bought for, but it is not the highest amount someone would be willing to pay.
Investopedia tells you: “Most people believe a stock's value is determined by its price. That's only true to a certain extent. But there is a real big difference between the two. The stock's price only tells you a company's current value or its market value.” Yes this is true, but it is not a functionally useful definition when considering what will actually drive changes in the price.
A company’s stock price is not the true value of a company’s equity. Nobody knows the true value of a company’s equity, not an individual investor, not company management and not the market as a whole. A company’s true value is the discounted value of its real future cash flows. We can make educated guesses what these future cash flows will be, but we cannot know for certain, and hence it is impossible to know a company’s true value.
On my definition, a share price is:
The equilibrium point where the available capital owned by Active Investors with a company valuation estimate greater than the current share price is equal to the number of shares (plus synthetic shares) available for active investors to purchase.
Hence a share price is changed by 3 key things:
- Changes in fair value estimates of individual investors that are currently invested in or valuing the company. These valuation estimates/share price targets do not have to be rational, analytical or even conscious. This could be investors that think that a stock is currently undervalued based on gut feel, it could be people that bought because they see upcoming positive catalysts which they think will increase the price (such as S&P 500 inclusion or M&A), it could be people buying based on signals from technical analysis. For people that do build a firm valuation model, there is still huge disagreement on which valuation methodologies to use and which fundamental assumptions to make about future cash flow. Some investors may make all their investment decisions based on multiples of historic financials. Some may make a single base case model and perform a discounted cash flow analysis. Some may make many or even hundreds of different models for future results and take a probability weighted average valuation. These valuations or gut feels will mostly be changed by changes to a company’s fundamentals, technicals or upcoming catalysts. Often there is a strong correlation between an investor's valuation and the actual stock price. For example at any moment the investor may always think the stock should be worth 30% more, and as the stock goes up they subtly tweak their models to justify this higher valuation. This is because emotion and gut feel is a far larger driver of investment decisions than investors like to admit (even to themselves).
- Increased or decreased pool of capital considering the stock & making fair value estimates. The pool of investors may increase because people simply had not heard about the stock before. It could increase because some investors had previously dismissed the stock based off a media narrative or equity analyst reports without ever forming their own valuation opinion, but when the narrative changed they decided to do some work. It could increase because investors had previously been unable to invest based on fund mandate requirements such as only profitable companies or only companies in the S&P or only dividend paying companies etc, and one of these factors now changed. The pool of investors may decrease because a fund decided to cut all exposure to a particular sector, or because the stock was too volatile and they decided it wasn’t worth the stress etc. Note that each individual investor only has a certain amount of their wealth or fund available to invest in a particular stock. So the pool of capital considering a particular stock is also constrained by position or risk limits, but these could also change up and down, particularly if a stock starts to be considered less risky.
- Changes to number of shares available for active investors to purchase.This can change due to share buybacks, changes in short interest, share issuance, purchases by passive index funds (which reduce the share pool available for active investors to use for their valuation based investments), share lock up expiry, changes in shares held by Options or Convert Delta Hedging etc. A reduction in these shares reduces the pool of shares that active investors are competing to buy and hence lowers the threshold of investor capital needed for the company to reach a particular share price.
To illustrate this with regards to Tesla.
- There is a certain pool of available capital available (for a single stock) controlled by Active Investors who have considered a Tesla investment and have formed their own view of valuation. Perhaps this is $150bn, perhaps $200bn, we don’t know. But each of these investors will have a view on whether Tesla is under or over-valued based off a financial model, technicals or gut feel etc.
- Currently there are 206m Tesla shares available for longs to buy – 180m real shares and 26m synthetic shares created by shorts. In reality Elon’s 34m shares are not available for active investors to purchase, so this leaves just 172m shares worth ~$69bn. Again, some of these shares are already held by passive funds tracking an index such as Russell, Nasdaq or MSCI, perhaps this is 10m shares, so again these are not available for Active investors to purchase. This leaves $65bn of Tesla long exposure available for Active investors to purchase.
- Of the say $200bn available capital controlled by Active Investors who have considered a Tesla investment, $65bn need to think Tesla is undervalued for us to achieve the current share price. Within the $200bn of potentially Tesla friendly capital there will be a wide distribution of views on valuation. $135bn thinks Tesla is worth less than $400 so would only invest if the share price fell below this level. Maybe $25bn thinks it is worth more than $600 so would only begin to sell if the share price rises above $600. $40bn have valuations between $400-600 and each would sell when share price rises above their valuation (unless they have changed their view on valuation in the meantime). These numbers are not estimates by the way, they are completely made up just for illustration.
So from here share price can change for 3 reasons:
- Change to the valuations made by this current $200bn pool of capital. This could be due to company specific or market wide reasons. For simplicity, if some event caused every single investor to increase their valuation by the same amount, say $50, then investors that were previously uninvested because they thought Tesla was worth $350-400, now think Tesla is undervalued (with valuations now ranging from $400-450. So these investors will now buy shares until a new equilibrium price is found. What exact price this moves to will depend on the distribution of different investor’s value estimates, but it will not likely be as high as $450.
- New investors considering a Tesla investment and adding to the $200bn pool of capital. This will change the whole distribution of valuations and will change the equilibrium point where the value of available Tesla shares is equal to the amount of capital valuing the company above the current share price. So this can change the share price even if no individual ever changed their Tesla valuation.
- Changes to the pool of shares available for active investors to purchase. For example since May the number of synthetic shares created by shorts has reduced by around 17 million. This has reduced the pool of shares available for active investors to purchase, and hence reduced the amount of Active investor capital needed to reach a particular share price. Similarly, if 20 million shares get bought by passive S&P 500 trackers, these shares will be removed from the pool of shares available for Active investors to compete over. These passive funds effectively have an infinite price target on Tesla because nothing will cause them to sell aside from changes in the size of their funds. So these things can permanently change the share price even if no investor changed their valuation and even if no new investor started considering an investment.
Just as a note. Instead, on the efficient market definition, which forms the foundation for much of financial theory and models, a share price is:
The true value of the company given all available information (presumably where the market has magically arrived at the correct answer because it is an infallible and emotion free superintelligence).
Hence a share price is changed by 1 thing: New information which changes the fundamental value of the company and is immediately perfectly reflected in the share price.
So on this definition a share price cannot be impacted by supply and demand. The change in available shares driven by changes in short interest, share buybacks, purchases by index funds, new investors, share lock up expiry etc cannot change the share price.
I'm throwing $20 plus per day into the wind. gas sucks. Not to mention diesel fumes literally gave me a respiratory issue 
