Markets and Fundamentals: A Model  101
price begins to fall. The noise investors accelerate the fall, but this slows as 
more and more informed investors begin to buy until, at $36, all informed 
investors are buying again, and the fall is reversed.
The pattern continues, with the share price oscillating within a band whose 
boundaries are set by the informed investors, as shown in Exhibit 7.1. If the 
noise traders act not only on price movements but also on random, insig-
nificant events, there will also be price oscillations within the band. The band 
itself can change over time, depending on the uncertainty among informed 
investors about the company’s intrinsic value. For example, product launches 
or successes in research and development can lead informed investors to in-
crease their value estimates as well as their trading bandwidth. As a result, 
price volatility will be temporarily higher while investors are absorbing the 
new information, as shown in the period after time T in Exhibit 7.1.
In this model, prices will move within the bandwidth if there is enough 
informed capital. This mechanism can break down, but only in rare situa-
tions. For example, when fundamental investors are vastly outnumbered by 
noise traders, their sales of stocks might not be able to stop a price rally. Such 
circumstances are unlikely, given the amounts of capital managed by sophis-
ticated, professional—that is to say, fundamental—investors today.6 Neverthe-
less, once they have sold all the overvalued stock, some fundamental investors 
can be reluctant to engage in short sales for fear of losing significant amounts 
before prices revert to lower levels. Others can face institutional or regulatory 
6 This is also what the academic literature predicts: informed investors outweigh and ultimately sur-
vive noise traders. See, for example, L. Blume and D. Easley, “Market Selection and Asset Pricing,” in 
Handbook of Financial Markets: Dynamics and Evolution, ed. T. Hens and K. Hoppe (Amsterdam: Elsevier, 
2009); and J. De Long, A. Shleifer, L. Summers, and R. Waldman, “The Survival of Noise Traders in 
Financial Markets,” Journal of Business 64, no. 1 (1991): 1–19.
EXHIBIT 7.1  Model of Share Price Trading Boundaries
100
90
80
70
60
50
40
30
20
Time
Time = T
Share price
Upper trading boundary
Upper intrinsic value
Lower intrinsic value
Lower trading boundary
Price

102  The Stock Market Is Smarter Than You Think
restrictions. As a result, the price rally might continue. But noise traders can-
not push share prices above their intrinsic levels for prolonged periods; at 
some point, fundamentals prevail in setting prices in the stock market. In ex-
treme cases, such as the technology bubble of the 1990s, this could take a few 
years, but the stock market always corrects itself to align with the underlying 
fundamental economics.
Markets and Fundamentals: The Evidence
In general, the empirical evidence supports the idea that growth and ROIC 
are the key drivers of value. That means the evidence tends not to support 
beliefs that value is shaped as much by other measures. Even some of the 
most conventional beliefs about the stock market are not supported by the 
facts. For example, most growth and value indexes, like those of Standard & 
Poor’s, categorize companies as either “value” or “growth” based on a combi-
nation of factors, including market-to-book ratios and price-to-earnings ratios 
(P/Es). Typically, companies with high market-to-book ratios and high P/Es 
end up in the growth category, while the others fall in the value category. How-
ever, growth is only one factor driving differences in market-to-book ratios 
and P/Es. ROIC also is important. In fact, we have found no difference in the 
distribution of growth rates between so-called value and growth stocks (see 
Exhibit 7.2). We did, however, find that so-called growth stocks tend to have 
high ROIC, and value stocks have lower ROIC. The median return on capi-
tal for so-called value companies was 15 percent, compared with 35 percent 
for the growth companies. So the companies classified as growth did not 
grow faster on average, but they did have higher returns on capital. That’s 
EXHIBIT 7.2  Distribution of Growth Rates for Growth and Value Stocks
0
–3
1
Growth
Value
Growth
Value
5
9
13
3-year average sales growth, %
Growth stocks do not grow materially faster . . .
. . . but do have higher ROICs
3-year average ROIC excluding goodwill, %
17
Value median
8.7%
Growth median
10.2%
21
25
2
4
6
% of companies
% of companies
8
10
12
14
0
5
–5
5
15
25
35
45
50+
10
15
20
25
30
35
Value median
15%
Growth median
35%