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Why do the share prices calculated from different models such as the dividend discount model or the free cash flow model or from the comparable analysis different than the actual stock price?

Like they always produce a result far different from the actual price. Why is that ?

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  • 4
    Are you looking for an answer that is more detailed than "because the models aren't actually very good, they're just the best we have"?
    – Vicky
    Oct 2, 2021 at 10:59
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    If someone has a model that actually works, than they are probably not sharing it but are sitting on a nice beach sipping Martinis.
    – Hilmar
    Oct 2, 2021 at 11:53
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    The behavior of the market will always be, at the very least, slightly more complicated than the best model humanity can build (well, the best model humanity has built). This is because if some model predicts what the market will do reliably, then the person who can compute that model's predictions will make investments that make money and, in the process, change what the market does to be not what its prediction was. Oct 2, 2021 at 18:22
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    Why does the weather often differ from what's been predicted a week ago? :) Oct 2, 2021 at 19:14
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    The only thing that affects real-world stock prices is humans deciding to buy or sell the stocks. Models are just nice toys for economists and financial advisors to play with.
    – alephzero
    Oct 2, 2021 at 19:52

4 Answers 4

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A model is a mathematical formula that tries to explain something or predict something based on a set of inputs or conditions.

The price of an item in a free market doesn't have to obey any model. If a bunch of people think that something will become more valuable or less valuable in the future that will drive the price change because people are either trying hard to buy it or dump it.

Prices have moved by great amounts on rumors and tweets. Prices have moved based on hints that country X will do something to balance their budget. Prices have moved based on the shape of the pattern of recent trades, even if those trades were unrelated to a model.

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  • What about the black scholes model? miltonfmr.com/…
    – CountDOOKU
    Oct 2, 2021 at 14:19
  • So how DO you invest in shares (as an individual)? based on what? Based on news? Based on herd? Just dump your money into a fund? Whats the point of these models? Why do they teach them in university courses?
    – CountDOOKU
    Oct 2, 2021 at 14:30
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    @CountDOOKU It's not that models are useless, but they're one tool to see if a stock is possibly over- or under-valued. No model can definitively predict the performance of a stock. Just because weather models are sometimes wrong does that mean they are useless?
    – D Stanley
    Oct 2, 2021 at 16:38
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    @CountDOOKU Things are taught in university courses because it is possible to set exam questions which have objectively "correct" answers. Most of what is taught in any undergraduate-level STEM course is at least 50 years out of date compared with the state of the art.
    – alephzero
    Oct 2, 2021 at 19:54
  • @CountDOOKU Models are useful when you're managing a portfolio with hundreds of stocks, or you're a financial planner with dozens of clients. It's hard to make all the individual decisions based only on personal knowledge, so models simplify the process.
    – Barmar
    Oct 3, 2021 at 2:08
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Tl:dr Finance/Economics is arts(social 'science') pretending to be science.

It's the bane of modern society. See Prof. Feynman's lecture "What is science" 1966. From an interview with the BBC:

“Because of the success of science, there is a kind of a pseudo-science. Social science is an example of a science which is not a science. They follow the forms. You gather data, you do so and so and so forth, but they don’t get any laws, they haven’t found out anything. They haven’t got anywhere – yet. Maybe someday they will, but it’s not very well developed.

"But what happens is, at an even more mundane level, we get experts on everything that sound like they are sort of scientific, expert. They are not scientists. They sit at a typewriter and they make up something like ‘a food grown with a fertilizer that’s organic is better for you than food grown with a fertilizer that is inorganic’. Maybe true, may not be true. But it hasn’t been demonstrated one way or the other. But they’ll sit there on the typewriter and make up all this stuff as if it’s science and then become experts on foods, organic foods and so on. There’s all kinds of myths and pseudo-science all over the place."

Also refer to Soros' Reflexivity theory, specifically his book "The New Paradigm for Financial Markets." which lays the blame, quite damningly, for the 2008 crash and depression on treating finance and economics as a science. The number one critic of the book was Paul 'Always Wrong' Krugman. The old adage is correct: Economists spend half their lives designing models and the other half explaining why they didn't work.

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Price is based on whatever human beings are willing to pay for it (or not). Prices get "too high" and so people sell and they fall until they are "too low" and then people buy and they rise. No model can ever hope to predict that with accuracy. The markets are human beings buying and selling and are unpredictable except in the very shortest of terms (seconds, milliseconds, etc.) which is why HFTs make so much money.

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The value of a stock is determined by the people buying and selling it and their believes. The value of a stock is not necessarily determined by the value/success of a company, except if people belief those two to be related.

Models are valuable in that they might be used to predict how people might end up feeling about the stocks they own in the future.

Some (most) people like owning stock that are (more) profitable and dislike owning stock that make long term losses. Not because there is anything rational about that, but "just because". Thus one might use models to identify stocks that might become more or less attractive to significant groups of stock owners.

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