Reflexivity: How stock prices can influence underlying values?

The Reflexive Relationship Between Market Price and Underlying Value

A complicating factor in securities analysis is the reflexive or reciprocal relationship between security prices and the values of the underlying businesses.

In The Alchemy of Finance, George Soros stated,
"Fundamental analysis seeks to establish how underlying values are reflected in stock prices, whereas the theory of reflexivity shows how stock prices can influence underlying values."  

In other words, Soros's theory of reflexivity makes the point that its stock price can at times significantly influence the value of a business.  

Investors must not lose sight of this possibility.



Examples:

1.   Most businesses can exist indefinitely without concern for the prices of their securities as long as they have adequate capital.  When additional capital is needed, however, the level of security prices can mean the difference between prosperity, mere viability, and bankruptcy. 

• If, for example, an undercapitalized bank has a high stock price, it can issue more shares and become adequately capitalized, a form of self-fulfilling prophecy.  The stock market says there is no problem, so there is no problem.   
• Example:  A company stock traded in the teens and the company was able to find buyers for newly issued securities.  If its stock price had been in the low single digits, however, it would have been unable to raise additional equity capital, which could have resulted in its eventual failure.  
• This is another, albeit negative form of self-fulfilling prophecy, whereby the financial markets' perception of the viability of a business influences the outcome.

2.   Another form of reflexivity exists when the managers of a business accept its securities' prices, rather than business fundamentals, as the determining factor in valuation.  

• If the management of a company with an undervalued stock believes that the depressed market price is an accurate reflection of value, they may take actions that prove the market right.  
• Stock could be issued in a secondary offering or merger, for example, at a price so low that it significantly dilutes the value of existing shares.

3.   As another example of reflexivity, the success of a reorganization plan for a bankrupt company may depend on certain values being realized by creditors. 

• If the financial markets are depressed at the time of reorganization, it could be difficult, perhaps impossible, to generate agreed values for creditors if those values depend on the estimated market prices of debt and equity securities in the reorganized company.  
• In circular fashion, this could serve to depress even further the prices of securities in this bankrupt company.

4.   The same holds true for a highly leveraged company with an upcoming debt maturity.  

• If the market deems a company creditworthy, the company will be able to refinance and fulfill the prophecy.  
• If the market votes thumbs down on the credit, however, that prophecy will also be fulfilled since the company will then fail to meet its obligations.

Conclusion:

Reflexivity is a minor factor in the valuation of most securities most of the time, but occasionally it becomes important. 

This phenomenon is a wild card, a valuation factor not determined by business fundamentals but rather by financial market themselves.