Rational Equity Valuation at the Time of the South Sea Bubble

Persistent stock-price increases that have a questionable link to a firm's fundamentals are often portrayed as irrational bubbles. While the recent performance of Internet stocks is the latest example, the South Sea Bubble in 1720 is often exemplified as the epitome of the irrational equity bubble. Some criticism of Internet investors has suggested that they behave irrationally and ignore fundamentals; that criticism occasionally draws comparisons between on-line investors and participants in the South Sea Bubble, an investment scheme in which, it is typically assumed, investor behavior was irrational and unsophisticated.¹

In this article I examine equity valuation at the time of the South Sea Bubble. My intent is not to calculate an ex post rational value for South Sea stock (after all, ex ante, there will always be some growth path to justify the observed price), but rather to investigate the methodology of equity valuation at that time. Contrary to popular perceptions, investors in the early eighteenth century, and even during the height of the bubble, used modern valuation techniques based on fundamentals and that were strikingly similar to those of today. The existence and use of such valuation methods cannot establish that the bubble was rational, only that the economic principles underlying market analysis and valuation were well understood by investors almost three hundred years ago.

Two related, and important, revisionist accounts of early bubbles have already appeared. Peter Garber (1989, 1990) proposes market fundamental explanations for early bubbles, including the South Sea Bubble and the Dutch tulipmania, and Larry Neal (1990a) emphasizes the importance of rational structural features in the South Sea Bubble such as leverage, credit, and liquidity.² This article supplements those two by establishing, in the context of the stock market, the existence of valuation “fundamentals” and of a well-known approach for translating the fundamentals into a price. The 1720 valuation techniques can be characterized, with scant embellishment, as a dividend discount model and/or a price/earnings ratio.

Background

Even in 1720 (never mind 2001), equity valuation was not a new phenomenon and neither were questions about fundamental value. Equity shares date back to the incorporation of the Dutch East India Company in 1602, and shares were actively traded and valued, in both Amsterdam and London, long before the advent of the South Sea Bubble in 1720. In fact, daily stock-price quotations were being published by London brokers for interested parties around 1700 (see, for instance, John Caisting's The Course of the Exchange, which is described in Neal 1990b). Moreover, because the stock market was controversial, the London stock trade was the focus of a vigorous pamphlet press in the early 1700s that provides insight into the early valuation of stocks.

The pamphlet literature I examine reached its peak around the time of the South Sea Bubble. However, I draw on earlier writings to complete the picture. These pamphlets were mostly written with the aim of influencing government regulatory policy toward the stock market. Harrison 1999 shows that government regulation of the stock market was indeed responsive to public opinion. The pamphleteers tended to criticize the trade in stocks (and the stock “jobbers”—as traders were called), although a number were obviously defensive responses by stock-market proponents. The criticism took on many different forms, some of it moral and social, but much of it economic (see Harrison 1997). The most prominent form of economic criticism ultimately rested on the inappropriateness of the market price. In order to argue that the price was “wrong” (or “imaginary”), these critics often provided a detailed analysis of what the fundamental price should be. This “right” price was called the “Intrinsic Value” of the stock.³ Thus, regardless of the author's position with respect to the stock market, there was a persistent appeal to rationality in equity valuation at that time.

Intrinsic Value

Intrinsic value for most early-eighteenth...