It's no coincidence that last week, as the minutes from April's Federal Reserve meeting suggested interest rates won't go up for months or even years, Web professional network company LinkedIn went public at $45 a share. Its stock zoomed past $100 per share and settled at $94 on the first day. This valued the company at $9 billion, 30 times sales and 666 times earnings.
Overvalued? Undervalued? Stocks are worth whatever the market says they are worth. On Wall Street, perception becomes reality, though often fleeting. Of course, it's not a real market. First, less than 15% of most IPO shares trade freely for the first six months (by longstanding practice, the rest are locked up). Worse, the Fed's current near-zero interest rate policy distorts everything.
Let's go back to fundamentals. Put simply, a stock is worth the sum of what investors think it will earn in the future discounted back to today. No one really knows a company's earnings, its growth rate, or what discount rate or risk adjustment to apply. That's what makes markets such a wild and crazy ride—stock prices change minute by minute. Industry news, new product uptake, interest rates, inflation, risks of recessions or wars or tsunamis all pose some form of risk and change collective perceptions.
The primary function of the stock market is to allocate capital to companies whose prospects it likes and starve those it thinks are past their prime. Yet these allocations and reallocations are based on guesses.