Understanding the differences between market and business value and how they impact active and passive (or index-based) solutions highlights some of the unintended consequences that can arise from a passive-only approach to investing.

The current trading price of a stock, its market value, may or may not be a reflection of the underlying business value of the company it represents. Generally speaking, business value is the discounted value of future cash flows — it is a reflection of expectations for the fundamentals and financial position of the underlying company. Market value simply reflects the current trading price of a company's stock, largely based on supply and demand.

1

Over time, stock prices tend to track the earnings of the businesses they represent

Over the last five years, earnings growth has lagged market returns, leading to a significant divergence. Looking back over the last 25 years, however, we see that earnings growth and market returns are fairly similar despite such short-term divergences.

2

Business value reflects what an informed buyer would pay

An informed buyer will look at the unique qualities of the company's market, as well as the size of the company's market, its sector, stage of development, growth potential, customer base and competitor landscape.

3

Market value is influenced by sentiments outside of business fundamentals

The market value of a stock is not determined by a company's economic prospects; it is simply the price that an investor is currently willing to pay for the stock in the market. It is subject to the supply of shares and the demand for those shares.

4

Market value must eventually reflect business value

Although events such as the U.S. presidential election are catalysts for a change in the market, markets are forward looking. Much like campaign promises, time will either confirm current market valuations or show them to be too high or too low.

11.5%

The difference between the S&P 500's compound annual growth rate for total returns and EPS over 5 years.

1.2%

The difference between the S&P 500's compound annual growth rate for total returns and EPS over 25 years.

13%

The increase in proportion of passively managed equity funds, 2009–2015.

“The key difference between business and market value is the influence that broader sentiments — outside of the underlying fundamentals of the business — have on the price of a share in the company.”

While the price and forecast earnings per share (EPS) of the S&P 500 are highly correlated over time, they have recently diverged. Investors are left to wonder: Will expected EPS rise to meet prices, or will prices fall to better reflect future EPS?

It's important to maintain a long-term perspective
Businesses with valuations based on fundamentals don't typically keep pace in bull markets

Their restraint and caution often delays gratification during favorable market environments (such as when interest rates are low), and they often consolidate the market during troughs, when competitors have run themselves into the ground.

Active managers may not outperform in bull markets, but tend to succeed in the long run

Investment managers who focus on fundamentals take a long-term view, usually defined as a business cycle or the time between market peaks or troughs. Historically, these tend to be five- to 10-year periods.

If a company is mispriced, the market will eventually correct itself

Experienced investors should strive to align their strategy with this concept of purchasing stocks based on business not market value, while focusing on our goals and objectives.

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