Question

Is it better for a firm’s actual stock price in the market to be under, over, or equal to its intrinsic value? Would your answer be the same from the standpoints of stockholders in general and a CEO who is about to exercise a million dollars in options and then retire? Explain.

Solution

Stock price at Equilibrium

Ideally, a firm’s stock price should be equal to its intrinsic value. This is when the stock is in equilibrium, meaning there is no pressure for the price to change. When the market price equals intrinsic value, investors are indifferent between buying or selling, reflecting a fair valuation of the company. In an efficient market, this is the ideal state, with the stock price accurately reflecting its true long-term value.

Undervalued Stock

If the stock price is under its intrinsic value, the stock is considered undervalued.

From the perspective of stockholders in general, this is not ideal. While it might present an opportunity to buy more stock at a lower price, it also means the current value of their holdings is less than what the company is actually worth, according to its intrinsic value.
An undervalued stock can make the company vulnerable to a hostile takeover by corporate raiders, who see it as a bargain. If a takeover is successful, the current executives are likely to be fired.
However, if investors recognize that the stock is undervalued, they may begin buying it, which will eventually drive the price up toward its intrinsic value.
From the perspective of a CEO about to exercise stock options and retire, an undervalued stock is also not ideal. It means their options, which are tied to the stock price, are worth less than they could be if the stock price reflected its true intrinsic value.

Overvalued Stock

If the stock price is over its intrinsic value, the stock is considered overvalued.

From the perspective of stockholders in general, this can be short-term beneficial. They can sell their shares at a price higher than the stock’s actual worth, realizing a profit. However, this is not sustainable. Eventually, the market will correct the price to reflect the intrinsic value, and the stock price will likely fall.
From the perspective of a CEO about to exercise stock options and retire, an overvalued stock is highly beneficial. They can exercise their options, sell the stock at the inflated price, and make a substantial profit. However, this is unethical if the overvaluation was achieved by manipulating the company’s financial reports or misleading investors.

Differing Perspectives

Stockholders in general want the stock price to be at or near its intrinsic value, which is seen as a measure of its “true” long-term worth. Over the long run, maximizing the intrinsic value also tends to maximize the average stock price.
A CEO about to exercise options and retire may benefit from a temporarily overvalued stock, as it maximizes their short-term gains. However, this is often unethical.

Summary

For stockholders in general, a stock price equal to the intrinsic value is most desirable because it reflects the company’s true worth.

A CEO about to exercise options and retire may prefer an overvalued stock in the short term to maximize profits from their options. However, this is unethical if the overvaluation is achieved by manipulating the stock price or misleading investors.

In conclusion, while a CEO might benefit from a short-term overvaluation, the ideal situation for a company and its shareholders is for the stock price to align with the intrinsic value. This provides a fair valuation and reflects the company’s long-term potential

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