Understanding Stock Investing

February 3, 2005 2:16 PM

As a fledgling investor, I'm confused about a fundamental idea behind stock investing: When I buy a stock, unless I buy it during a company's Initial Public Offering (IPO), I'm actually buying it from another investor who's willing to part with it for some price. So although I'm paying good money for those shares of company ownership, none of it ends up providing working capital for the company itself-- the money they got in the IPO is all they'll ever get from the stock market. So my questions are: What are the market forces that are supposed to keep the company's market capitalization (current share price X number of outstanding shares) in line with a company's actual value (assets - liabilities)? Why are high (or low) stock prices important to companies? Why do companies care so much about "creating shareholder value?"
posted by Ironwolf to work & money (49 comments total)

Often, companies will hold significant reserves of their own stock, which they can sell on the open market as they wish to bring in cash (or trade to aquire another company). The value of such a holding is, of course, dependant on the stock price.

Executives will also often have significant holdings in their company's stock (or options to purchase their company's stock), so they're motivated directly by share price.

Finally, the shareholders vote for the board, so if they're unhappy with the stock's performance, the board risks being thrown out.

As for this question: "What are the market forces that are supposed to keep the company's market capitalization (current share price X number of outstanding shares) in line with a company's actual value (assets - liabilities)?", I'm not even sure that everyone would agree that such forces exist, especially in the short term.
posted by mr_roboto at 2:30 PM on February 3, 2005

Intelligent investors keep the company's market capitalization in line with a company's actual value. If an investor believes a stock is overpriced, he sells (or perhaps shorts); if he believes a stock is underpriced, he buys. In accumulation, millions of people doing this should, in theory, keep the price in alignment with the company's actual value. If you, an investor, think everyone else has gotten it wrong, then you can buy or sell accordingly.

Corporations are run for the benefit of their investors. Consequently, corporate management likes to keep stock prices high to please investors. Why do corporations care about shareholders? (1) Shareholders are the legal owners. Shareholders elect boards of directors. (2) More threateningly, can decide to sell their shares to another company that is attempting a hostile takeover. (3) Some corporations anticipate the need to raise additional capital in the future by selling secondary public offerings. It's to their benefit to have a high market price when they do so.
posted by profwhat at 2:31 PM on February 3, 2005

This is a brilliant question--because I have never understood the answer. And all the more so since the price of stocks fluctuates much more, and appreciates much more than the dividend it pays (if it pays a dividend).

So, I am left to believe that the real answer is that of mass hypnosis/the greater fool theory.

And yet it works, so...
posted by ParisParamus at 2:37 PM on February 3, 2005

Profwhat, I think the flaw in the forces you cite is that all such events are exceptional, rare. Most stock is never bought back, or bought on such a basis.
posted by ParisParamus at 2:39 PM on February 3, 2005

What are the market forces that are supposed to keep the company's market capitalization (current share price X number of outstanding shares) in line with a company's actual value (assets - liabilities)?", I'm not even sure that everyone would agree that such forces exist, especially in the short term.

One answer is profwhat's b). If the stock is too cheap compared to the "value" of the company then a potential acquirer could try to buy out the stock to gain control of the company. Of course, just this potential for a buyout would raise the price on the market as investors anticipate that their stock could be tendered to the acquiring company.
posted by vacapinta at 2:41 PM on February 3, 2005

I've thought about this exact same question for many years now. And honestly, I think the only thing that ties the value of the stock to the value of the company is the collective belief of buyers and sellers that the value of the stock is tied to the value of the company.

I'd actually find it very interesting if someone could offer some concrete proof that I'm wrong about this.
posted by Clay201 at 3:03 PM on February 3, 2005

Mr. Roboto covered most of it correctly--especially why companies want high stock prices. I second his answer.

Separately, another way to think of stocks is that when an investor buys a stock, he is buying a fraction of the company--the same as you could buy a fraction of any asset (a painting, a house, etc.) with a group of people. How do you know that the price of the fraction is worth what you paid? Generally, you look to what other people would pay--i.e., the open market price. This is exactly how all other assets are priced--a famous painting is worth $10 million only because that is how much people will pay for it; it has no intrinsic economic value.

In some ways, stocks make more sense than paintings. A share of stock has an intrinsic economic value in that (A) the share might entitle the holder to dividends (cash payments) in the future or (B) because the holder may receive a buy-out premium when someone seeks to buy the shareholder's company. Even if there is no dividend or buy-out on the horizon, there is a future chance of those events, leading to a probabilistic value.
posted by Mid at 3:20 PM on February 3, 2005

Stock prices are tied not to the current value of a company, but to the expected future value of the company, including the profits it stands to reap over the next several years (which will either be reinvested in the company, increasing its value, or distributed to stockholders as dividends). They're not tied all that firmly, because there are several different ways of calculating an expected future value, and there is always the possibility that the company will unexpectedly take off or fail. Also, people are not always rational.

What keeps them tied, to the extent that they are in fact tied, is simple market economics. If people believe that a stock is undervalued (i.e. the stock price is less than its expected future value), they will buy it, or be reluctant to sell it if they already own it, increasing demand and/or reducing supply and thereby driving the price up. If they feel it is overvalued they are more likely to sell it (increasing supply) or not buy it (reducing demand), driving the price down.
posted by kindall at 3:21 PM on February 3, 2005

You also have to take into account that the "stock market" is not really just this collection of individuals who own shares as part of a personal portfolio. I'm not sure of the exact percentages (I'd be interested if anyone could find out) but the vast majority of stock shares are owned and actively traded by "institutional investors"--basically banks (investment and retail) and funds (mutual, pension and hedge).

Any one of those investors can easily own 10%, 20% or more of a company--even really large Dow companies--and collectively, 50% or more of a company's stock can be held by just a handful of institutions.

Those institutions definitely look at their investments as "real" money--they trade their portfolios very actively. They have very concrete expectations for when and how they expect to sell a given company's stock, usually in very complex stages, and as far as they're concerned, it's management's job to make sure the stock performs like they expect it to. If the current management can't make the stock price "behave", they'll push to find someone who can.

To give an extreme example, you can imagine how 10-15 powerful investors, who collectively own the majority of a company's shares, would basically run the company. They could pick and choose the executive team, decide the strategy, force or quash acquisitions, all because it was basically their company. (They might have to do it through the board, but it would still basically be the case.)

The reality is usually a diluted example of that, but the fact remains that most stock is held by those institutional entities. When a company's management talks about "creating value for the shareholders", then without question, _that's_ who they're talking about. Not you and me.
posted by LairBob at 3:22 PM on February 3, 2005

Corporations are run for the benefit of their investors.

I think that's the main thing. The company is the stock, and it's whole theoretical purpose is to generate future dividends for the stockholders. The company is not the CEO or the rest of the executive management. It's the stakeholders and the board.

The only reason stocks have any value at all is that they are expected to make dividend payments now or sometime in the future. Although most people buy and sell stocks based on how much they think other people are going to want to buy those stocks, the only reason anyone wants any stocks at all is that stocks pay dividends. What good would they be otherwise?
posted by tirade at 3:31 PM on February 3, 2005

Actually, on Googling, I just found a PDF article that says that “Large” institutional investors -- a
category including all managers with at least $100 million under management -- nearly doubled
their share of the common stock market from 1980 to 1996. By December 1996, these large
institutions held discretionary control over more than half of the U.S. equity market.

So with that kind of growth in their share in the market, you can imagine they're at around 60% or more, nowadays. Beyond that, though, that article also ways that within this group of large institutions, ownership became more highly
concentrated: the one-hundred largest institutions increased their share of the market from 19.0
percent in 1980 to 37.1 percent in 1996, so the actual effect is even more exaggerated.

Mind you, I'm not some huge anarchic anti-oligarch. I'm just pointing out that what people really mean when they say "shareholder" isn't John Q. Public--it's these institutions.
posted by LairBob at 3:36 PM on February 3, 2005

You might enjoy reading "A Random Walk Down Wall Street" by Burton G. Malkiel. It talks in pretty straight-forward terms about the different theories regarding how stocks are valued. Here's an article about valuation on the The Motley Fool.

To answer "What are the market forces that are supposed to keep the company's market capitalization": that would be investors who decide what they are willing to pay for a stock. Unfortunately, because we investors are uninformed and prone to being human, we're seldom correct.
posted by theFlyingSquirrel at 3:41 PM on February 3, 2005

A couple separable points (as I understand things).

First, as a stock holder you own a portion of the company. So if a company had no debt, assets of $1 Billion, the company had 100 million outstanding shares, and you owned 100 shares, then each share would be "worth" ($1000M/100M) = $10, and your 100 shares would be worth $1,000. This is the money you would receive if the company liquidated itself.

Second, companies are in business to make money. So if a company makes $100 million in net revenue this year, this means that the company would have assets of $1.1Billion and your shares would be worth $11.

Now, you won't find very many situations where you can buy stock at this level for this hypothetical company. In fact, stock for this company could be something like $20 (or any other imaginable number). The reason the stock is $20 is that people believe that the comapny will continue to make money until it had more than $2 Billion in assets at some point in the future. This is where the faith in the future come in. Nothing guarantees that the company won't go belly up in the next few years, but people are BETTING that it doesn't.

I'm sure others may be able to explain it better ...

on preview, what mid and kindall said ....
posted by forforf at 3:41 PM on February 3, 2005

The only reason stocks have any value at all is that they are expected to make dividend payments now or sometime in the future. Although most people buy and sell stocks based on how much they think other people are going to want to buy those stocks, the only reason anyone wants any stocks at all is that stocks pay dividends. What good would they be otherwise?

I think this is a little misguided. First of all, not all stocks pay dividends. Second, most wealth that is created in the stock market is created not from dividend payments but from long-term appreciation in the value of shares. Finally, there are many investors who are interested only in short-term speculation. They make (or lose, as the case may be) money from fluctuations in stock price over a period of days, weeks, or months, and they couldn't care less about dividend payments.

While dividends can be beneficial to investors (particularly those, such as retirees, who need to make an income from their investments), they're not generally a motivating factor in investing.

LairBob:

Keep in mind that some of the biggest of those institutional investors are state pension funds. In fact, I believe that the biggest institutional investor in the U.S. is the California state employees' retirement fund. These fund managers are ultimately responsible to the voters, introducing a weird sort of economic democracy into the whole system.
posted by mr_roboto at 3:44 PM on February 3, 2005

Dude, the stock market is a pyramid scheme. Invest in it if you want. I do. But know that at some point in the future it is going to collapse and someone is going to be left holding the bag. That someone could be you or me, or could be our grandchildren. The money we make off of the market today, just like the money made by the investors I bought my stocks from, and just like the money I'll make when I sell my stocks at a profit is a debt that someone eventually will be left with when everything crashes.
posted by pwb503 at 3:45 PM on February 3, 2005

Unfortunately, I agree with PWB503. But it's a somewhat "anticipatable" pyramid scheme. I think.
posted by ParisParamus at 4:19 PM on February 3, 2005

I think this is a little misguided. First of all, not all stocks pay dividends.

Yes they do. Many don't right now, many haven't ever, or haven't for years, but there's an expectation that at some future point the company will pay dividends. Otherwise, as I said, that stock is of no use to anyone. A stock which is guaranteed to never, ever pay a dividend has an automatic practical value of 0. I'm pretty certain I'm right about this.

Second, most wealth that is created in the stock market is created not from dividend payments but from long-term appreciation in the value of shares. Finally, there are many investors who are interested only in short-term speculation. They make (or lose, as the case may be) money from fluctuations in stock price over a period of days, weeks, or months, and they couldn't care less about dividend payments.

You're right about the above, which is also why I noted that, "Although most people buy and sell stocks based on how much they think other people are going to want to buy those stocks..." But I don't think you got what I was saying.

People speculate in the stock market based on the market forces: how much other people are going to want a stock. But the only reason people are fighting over stocks in the first place - the only reason those stocks have value - is that they will pay a dividend. Think about it. A company that doesn't pay dividends is a non-profit company.


While dividends can be beneficial to investors (particularly those, such as retirees, who need to make an income from their investments), they're not generally a motivating factor in investing.

The initial question wasn't so much why people invest as why companies go public - what's the point? Which is what I answered in the initial post. The reason you put 410K money into a mutual fund, or daytrade, is completely different from the reason these things called "stocks" exist in the first place and the purpose they serve for the company. Or put another way, speculative investing and share ownership are two different things.
posted by tirade at 4:34 PM on February 3, 2005

mr_roboto, granted. The guy who was in charge of the California pension fund was actually a pretty aggressive corporate reform activist (and, of course, was just removed from the position a couple of months ago).

Regarding the whole "pyramid scheme" thing, I think you're overstating the likelihood of a systemic collapse. The biggest difference between today's stock market compared to the market of the '20s isn't really regulation, or the various safeguards that have been built in--although those are important--it's the size of the market, and the relative sophistication of the market.

Instead of one _big_ crash, what you've really got is sort of a distributed series of running crashes, that are at least mitigated, on the whole, by gains or even just stability in other areas. Look at the whole "dot-com" crash--sure, shares in that area got creamed, and the overall indexes like the Dow went down, but they were kind of crazy-valued anyway, and the whole thing ended up sinking to earth a lot more rationally than you might have expected from such a body blow.

I don't mean to be all Pollyann-ish about it, and I'm not personally a huge "market forces solve everything" kind of guy, by any means. But I do think the current market has evolved into a relatively robust system, and I don't share your pessimistic _certainty_ that it's all going to come crashing down.

Things may get tough, in different ways at different times, but I think it'd take a pretty remarkable event to really just eviscerate the market--the kind of thing that would make the stock market the least of your worries.
posted by LairBob at 4:36 PM on February 3, 2005

Fundamentally, I don't believe it is a pyramid scheme. The net present value of a company should be the sum worth of all of its shares. As a company creates wealth, by turning a raw material into a product or delivering a service, or whatever it does that other people find valuable, the value of the company may increase, etc, etc.

The reason I agree that as it stand the market is a pyramid scheme is the "fees" taken out by wallstreet types that are not in proportion to the value they add, and the out-and-out corruption that sucks the wealth out companies and into the hands of CEOs and board members.

I'm not sure if the system can correct itself or not, but I guess we'll see and I'm betting that I can make a profit before it crashes.
posted by gus at 4:44 PM on February 3, 2005

And tirade, I'm not really sure how you can be so confident in your assertion that "the only value of a stock is its (potential) dividend", when it just seems to fly in the face of so much real-world evidence.

When's the last time you saw an analyst upgrade or downgrade a stock based on its dividend? When's the last time you saw a stock newsletter or column that focused on the dividend as a reason to buy or sell a given stock? More to the point, when's the last time you saw some kind of stock tracker that let you track stock dividends?

I'm not saying that the potential dividend isn't a legitimate criterion for valuing a stock, and even that maybe it isn't a better one than what most investors use, but it seems pretty clear that the era of valuing a stock by its dividend went away a long time ago. The huge majority of investors today buy stock (or short) stock on the expectation of its future share value--the potential dividend may play a role in that expectation, but that's definitely not why people are buying or selling shares.
posted by LairBob at 4:57 PM on February 3, 2005

Check out the Intelligent Investor. That will give you a better answer to what is the value of investing and the importance or lack of a price per share.

Mr. Market is one (read the book.) "The invisible hand", the overall economic confidence level, the access to timely/quality information, insider information, the SEC, and as mentioned before large institutional investors are some of the forces affecting the price.

I would say, high or low prices shouldn't bother the company at all. It's only there to help judge what size and type of fish you are. Probably a poor example.

As for creating value, if they don't then you as an owner can bring about the changes necessary to get your way and run the company as you see fit. Warren Buffett has a knack for that, in turning out profits and going along for the ride.

As for those pyramid schemes, they are not only likely to occur, but would be corrected as long as you have people willing to take a risk. Exactly what you are doing by investing in the first place.
posted by brent at 5:09 PM on February 3, 2005

Lairbob:

I don't know what to tell you, since I already said it all above. You don't get what I'm saying.

Go back and read what I said again. Or better yet, tell me, why does anyone want to buy stocks? Because they think other people are going to want to buy it back from from them for more later? Ok, but why do those people want the stock? The arguments you're making really do paint the stock market as a pyramid scheme - a bunch of people who only want something with no intrinsic value because someone else wants it. That's not really how it works.

That's how BeanieBabies collecting worked, and look where that went. That's how the dotcom bubble or the tulip bulb craze worked, and there's a reason that when they crashed, people called it a market correction. A return to the correct value of things. Now, where does that correct value come from? Why do stocks have value?

The reason people invest in stocks, instead of, say, pieces of construction paper, or leaves, is that stocks entitle you to the profits of a company.

The only reason that public companies exist is to generate a profit and pay it to the shareholders through dividends. If a public company is not paying dividends right now, that's only because they want to reinvest money into growing the company so that they can pay even bigger dividends later. The company does not exist to pay employees a salary - the only reason the employees are there, all the way up to the CEO, is because the shareholders hired them to run the company. The reason they are hired to run the company is to generate profits which are then given to the shareholders via dividends.

I'm no market whiz. Someone correct me if I'm wrong.
posted by tirade at 5:16 PM on February 3, 2005

Tirade -- you are ignoring the fact that companies get purchased all the time. E.g., SBC is buying AT&T. Qwest might buy MCI. Etc. Etc. This happens all the time.

To buy a company, you gotta buy all the stock. Not only that, you usually have to pay a premium. That means putting cash in the hands in the shareholders.

An investor could rationally buy a stock never expecting a dividend, but expecting a buy-out. A stock's price thus reflects (in part) the future prospects of a buy-out.

Indeed, plenty of companies have no profit and no ability ot pay a dividend. The shares of those companies might be valuable nonetheless because of the prospect of a buy-out.

Also, there is nothing non-real or non-economic about the speculative value of shares. The money in your pocket has no inherent value--it is worth what people say it is worth. Same with a Picasso or first-edition Hemingway. Same with gold, excepting industrial uses. All of the "pyramid scheme" stuff and similar thoughts on this thread could just as easily be applied to the money in your checking account--which doesn't even exist except in some digital notations in a computer somewhere!
posted by Mid at 5:22 PM on February 3, 2005

Actually, tirade is not correct. The easiest way to look at a share of stock is (as others have commented), as a share of the company. There is no expectation that you will get anything other than shared ownership of the company.

Shares of stock exist not only in public companies, but also privately held companies. Often stock is distributed to emplyees with the lure that the company might go public and the employees can sell their stake in the company easily on the stock market.

Figuring out the value of a stock is obviously tricky, because most of it has to do with the future value of the company as a whole. A good way to think of it is that if someone wanted to buy the company, they would have to pay the total value of the number of shares outstanding, multiplied by the share price. How much would someone be willing to pay for a company and how much would a company be willing to sell for? That amount is often tied to the revenue of the company, because that is how much a buyer could expect to make if it took over. If a company is selling a lot of product, but not making much money on each sale, it is not going to be worth buying at a premium compared to its book (asset) value.

When public companies purchase other public companies, they often do a stock conversion, where shareholders of the purchased company are given some multiple (could be less than 1) shares of the purchasing company in exchange for their shares. The board of the purchased company votes on how much they will accept for the company on behalf of the share holders. The share holders elect the board, so they don't explicity approve of the sale.

Creating shareholder value can work to keep a company stable. If the shareholders think that the company is a piece of crap and start selling, the overall value of the company dives. It becomes easier for another company to come in and buy it out. It is harder to raise capital because the company still retains a lot of stock. A company probably gives some stock to its employees, if suddenly thier stock is worthless, they probably aren't going to work too hard.

IPO prices are generally set at some multiple of a companies projected future earnings. It's another crapshoot and when .coms were going crazy, there was really no historical data to set prices, neither in the industry or for the company itself. That is one reason that things flamed out so spectacularly, there was nothing but emotion to set valuations and expectations.

Not sure if any of that makes sense. I'll try to boil it down to the simple statement that owning a share of stock is owning a share of the company. Just like anything bought and sold, there is a mix of true valuation combined with perception in the price.
posted by jonah at 5:27 PM on February 3, 2005

The only reason that public companies exist is to generate a profit and pay it to the shareholders through dividends.

Not exactly true. Public companies exist to grow. If a public company is not growing, it might as well delist itself. There is no implied sharing of profits through dividends. Dividends are often used to keep investors from selling stocks which have steady profit, but not large growth.
posted by jonah at 5:39 PM on February 3, 2005

A stock which is guaranteed to never, ever pay a dividend has an automatic practical value of 0. I'm pretty certain I'm right about this.

I'm not sure where you got this idea. A stock is a share of ownership in a corporation. If the corporation has value, the stock has value.

What's more, there exist a market for trading in stocks. So long as there is some demand for a stock, and a limited supply of that stock, the stock will have value.

Here's a link to Google's IPO prospectus. It includes the following:

We do not intend to pay dividends on our common stock.

We have never declared or paid any cash dividend on our capital stock. We currently intend to retain any future earnings and do not expect to pay any dividends in the foreseeable future.

Does this mean Google common stock has no value? The market certainly doesn't seem to think so.

In fact, even with Bush's dividend tax reduction, the market shows no preference for dividend-paying stocks over non-dividend stocks. Are you saying that the market fails to reflect the fundamental inherent value of stocks?
posted by mr_roboto at 5:40 PM on February 3, 2005

Some nitpicks:

Those institutions definitely look at their investments as "real" money--they trade their portfolios very actively.

Not really. Insurance companies and pensions do very little trading. Mutual funds usually have average holding periods in excess of one year. Hedge funds trade frequently.

I'm just pointing out that what people really mean when they say "shareholder" isn't John Q. Public--it's these institutions.

This may just be semantics, but in almost all cases, the shareholder is John Q. Public. Who do you think owns all of these mutual funds and insurance policies?

Dude, the stock market is a pyramid scheme.

It's probably true that the DJIA will someday be valued at 0, but that doesn't make it a pyramid scheme.

Check out the Intelligent Investor.

The best book about stocks.

The board of the purchased company votes on how much they will accept for the company on behalf of the share holders. The share holders elect the board, so they don't explicity approve of the sale.

Not always true.
posted by trharlan at 5:42 PM on February 3, 2005

tirade, I did read what you wrote. Just because I don't find it convincing doesn't mean I wasn't paying attention.

Regarding the substance of your points, I think that my points, along with those that Mid and jonah made, help pretty clearly at least address the your argument. You may not find it convincing, but I really do think our comments have been pretty specific.

In terms of the "pyramid scheme", for example, I've already tried to explain that I _do_ believe the market is basically a rolling pyramid scheme. I don't think that's a great thing, but the fact that that's how it works doesn't validate or invalidate the whole "share value vs. dividend" thing either way, in any way that I can see.

I guess the toughest thing to address is your challenge "Or better yet, tell me, why does anyone want to buy stocks?--not because it's a convincing argument, but because I can't think of a better argument than the real world, and if you're not convinced by that, I just don't know what else to say.

There's just an overwhelming body of evidence out there that people buy stocks for reasons other than "dividend" _all_ the time. When you look at all the analyst reports, columns, message boards and other real-word forums where people talk about _why_ they buy or sell stocks, you don't see _any_ discussion of dividends as a reason why. They all talk about share value as the core reason why you should or shouldn't invest in a given company, and if they mention dividends at all (which they rarely do), they talk about them as something that affects the future share value for when you would want to sell it.

So if you don't want to accept that argument, then fine, let's just leave it at that. If you could point me to some large body of investor commentary that focuses on potential dividend value that I've missed somewhere, then I'd really appreciate that. In the meantime, though, again...I'm not disagreeing, in principle, that potential dividend value _should_ be a good yardstick. I just think that there are a _lot_ of different reasons why people _do_ buy stocks, and one specific reason--share value--that is the overwhelming reason that most investors do.
posted by LairBob at 5:44 PM on February 3, 2005

Insurance companies and pensions do very little trading. Mutual funds usually have average holding periods in excess of one year. Hedge funds trade frequently.

I agree and I don't agree. Broadly, yes, insurance and pension funds don't make as many investment decisions as hedge funds do, but one of the more surprising discoveries I made when I started working in the investment sector was how much transaction activity even pension funds have.

Sure, they don't trade like a hedge fund, which swap shares on a minute-by-minute basis, but even one decision by a large pension fund can result in a _ton_ of individual transactions. Typically, if a fund manager wants to change their position in a company, they'll wind it down or crank it up over many days--they don't want to just buy a million shares at a time, and move the market just by doing that.

Instead, they'll schedule a series of buys or sells over several days or weeks, and with the number of holdings that they have, if they even have a small percentage of adjustments, they still generate an enormous amount of day-to-day transactions. They do tend to move their positions much more slowly, over time, but they still have a ton of transactions, and so are pretty sensitive to share price on a day-to-day basis.
posted by LairBob at 5:55 PM on February 3, 2005

'Why do companies care so much about "creating shareholder value?"'

Because that's what their owners, the shareholders, want. In some cases, the company itself is a rather substantial shareholder, but it hardly matters -- the people who own lots of a stock want it to increase its value.

"The company" and "the shareholders" are not the wholly separate and independent entities you seem to perceive them as. The company is the property of those shareholders; it's in their best interest to increase the value of their property.
posted by majick at 6:58 PM on February 3, 2005

"What are the market forces that are supposed to keep the company's market capitalization (current share price X number of outstanding shares) in line with a company's actual value (assets - liabilities)?"

Market capitalization/book value is one of the most important ratios used in "value" oriented investing. As the name implies, it is oriented toward buying stocks that are cheap relative to their book value. If the price to book value is too high, a value investor would not buy it. Value vs. growth.

So basically, the market force is: 1) a body of literature that shows that companies with a low price/book value have generally offered nice returns in the past, and 2) investors acting on this information.
posted by milkrate at 7:15 PM on February 3, 2005

There's just an overwhelming body of evidence out there that people buy stocks for reasons other than "dividend" _all_ the time. When you look at all the analyst reports, columns, message boards and other real-word forums where people talk about _why_ they buy or sell stocks, you don't see _any_ discussion of dividends as a reason why.

Because, as I've said, you keep coming back to speculation, which is not what we're talking about. The guys on CNBC and IBD trying to analyze stocks are trying to guess at future demand for those stocks, which, yes, is really only loosely related to dividend payments. Microsoft, I think, only recently paid its first dividend, and we know their share prices have been doing pretty well since the 80s. The reaons share prices are what they are is that they are a limited resource with varying demand. A lot of people want a finite amount of available shares, so the price goes up.

When I say dividend is the reason stocks have value, I'm not saying Company X has a share price of $Y purely because of a scheduled $Z dividend. I'm saying that the reason stocks - in general, not specific stocks - are bought and sold at all, is that they entitle you to the profits of that company.


They all talk about share value as the core reason why you should or shouldn't invest in a given company, and if they mention dividends at all (which they rarely do), they talk about them as something that affects the future share value for when you would want to sell it.

And where does that share value come from? I'm far, far away from my old finance textbook, but as I recall value investors arrive at the intrinsic value for a stock by using something similar to a standard annuity discounting equation based on the expected future payment of dividends. Anyone know?

Granted, that's not how the guys on CNBC do it, but they're all hacks. If they could value shares, mutual funds would outperform the market. They don't. I think someone already suggested the book A Random Walk Down Wallstreet. Check it out. It's good.


Mr_Roboto notes:
Does this mean Google common stock has no value? The market certainly doesn't seem to think so.

In the grand scheme of things, the forseeable future is not such a long time. Google will eventually issue a dividend. It's not uncommon for growing companies to go for very long stretches of time w/o issuing dividends. Again, this is so that the company can reinvest - which in turn is solely in order to deliver greater shareholder returns down the road.
posted by tirade at 8:04 PM on February 3, 2005

I'm saying that the reason stocks - in general, not specific stocks - are bought and sold at all, is that they entitle you to the profits of that company.

That's simply not true. It's like saying that if the company loses money, that you are going to have to cough up some dough to them if you own stock.

I don't know how to say this without sounding like a personal attack, but tirade, you should really give up on this point.
posted by jonah at 8:16 PM on February 3, 2005

Here is a good article on dividends that might explain why you might have the impression that stocks prices are based on dividends.

From the article:

During the first part of the twentieth century, dividends were the primary reason investors purchased stock. It was literally said on Wall Street, “the purpose of a company is to pay dividends”. Today, the investor’s view is a bit more refined; it could be stated, instead, as, “the purpose of a company is to increase my wealth.”
posted by jonah at 8:35 PM on February 3, 2005

That's simply not true. It's like saying that if the company loses money, that you are going to have to cough up some dough to them if you own stock.

Actually, that's simply not true. There's that whole corporate structure thing that limits my liability in such a case. What can be lost is the original investment in the company - the sale price of the share during the IPO.

Here is a good article on dividends that might explain why you might have the impression that stocks prices are based on dividends.

Again, I never said that the current selling price of a given share is a direct relation to it's dividend.

Did you read your article? It makes my point for me:

you learned that, “a company should only pay dividends if it is unable to reinvest its cash at a higher rate than the shareholders (owners) of the business would be able to if the money was in their hands.

Which implies that the purpose of the company is to generate money for its shareholders. Someday it's got to give that money back, and it can only do that through paying a dividend.

I don't know how to say this without sounding like a personal attack, but tirade, you should really give up on this point.

Funny thing about that is it wouldn't have read like a personal attack if you hadn't put the words "personal attack" right in it. But you saying that doesn't bother me. No offense taken.

Shucks, I was gonna quote some Malkiel for you, but if you're all getting tired of me I'll go away. :)
posted by tirade at 8:59 PM on February 3, 2005

Liquidating dividend might be the term some of you are chasing after.

And FWIW, I know of no one at my office who uses a dividend discount model to value equity. It's always discounted free cash flow to equity/unlevered free cash flow (the cash the company is generating that it could use to pay its capital holders) and some stew of multipliers or ratios.
posted by milkrate at 9:03 PM on February 3, 2005

Funny thing about that is it wouldn't have read like a personal attack if you hadn't put the words "personal attack" right in it.

Well there's something we can agree on, that was pretty lame phrasing by me.
posted by jonah at 9:22 PM on February 3, 2005

And FWIW, I know of no one at my office who uses a dividend discount model to value equity.

Not even for REITs or mature utilities?
posted by trharlan at 9:29 PM on February 3, 2005

(or closed-end income funds?) Would you mind emailing me, milkrate?
posted by trharlan at 9:38 PM on February 3, 2005

When we value the equity in companies, it's usually for a takeover bid - no REITs. In the utilities we do, I've always done discounted FCFE w/ terminal multiple, and some comparable company price ratios.

For a REIT - which is legally required to pay out 90some% (?) in dividends - I'd imagine that's what they use. I have no connection to the RE business, though.
posted by milkrate at 10:45 PM on February 3, 2005

You realize how insanely complex this question is?

Milkrate -IBanker?

People buy the riskier asset of equties versus bonds because they are being compensated with a correspondingly higher rate of return.

Over the long-term share prices of companies tend to track present value of the future cash-flows they generate.
In the short-term the market can be extremely irrational.

People are indifferent between getting paid via capital appreciation or dividends.
With the caveat that companies with poor track records in re-investing the excess capital they generate will be punished for the value destruction that comes along with retaining that capital rather than paying it out. The theory being that I can make the re-investment decision better myself.

The argument for a Dividend based DCF vs a Free Cash Flow based DCF is that it allows you to capture the quality of the re-investment decisions. However there are guys who use all different sorts of methodologies who do a fantastic job of managing money so to say one is better than the other is probably wrong.
posted by JPD at 11:26 PM on February 3, 2005

To everyone who has responded: I am finding the answers to my questions (and the surrounding discussions and debates) quite enlightening-- I really appreciate the various perspectives.
posted by Ironwolf at 12:02 AM on February 4, 2005

Here's a thought experiment. Don't know if it helps, but it was fun to make up: Imagine you inherited a box that spits out five dollars every month. Except it's not exactly $5. Sometimes it's zero, sometimes $8. And as time passes you notice that the long-term average also fluctuates. Last year it spit out a total of $60. But the year before it spit out $56, and the year before that $63, the year before that $57. Not exactly random, but not entirely predictable either. But in general, with many exceptions, over the long term the yearly average seems to increase. Of course that could change at any time. It's anybody's guess.

Also, imagine this box re-swallows around 80% of the bills it spits out before you can grab them, but gives you 20%. You know that the bills it swallowed are inside the box, because the total of swallowed bills registers on a display on the side of the box. If you were ever to break open the box you could get all those bills, but the box would cease to exist as a money-spitting machine.

Now, you go on Ebay and offer to sell 30% ownership in the box. Everybody knows about the box, it's famous. You even took it on Oprah and showed it off. And your offer to sell 30% comes with a guarantee that an independent panel of bishops and Nobel prize winners will monitor the box and assure that the proceeds are fairly distributed. The successful bidder will receive 30% of the bills that remain un-swallowed (30% of 20% of the total bills generated), and a 30% ownership in the box itself, which includes 30% of all the bills in the box. And that new part-owner is free to re-sell all or part of his ownership at any time. Lots of people would love to own a share in the box and its future proceeds, it'd be easy to re-sell.

How much is that 30% worth? Well, at a minimum it appears to be worth 30% of the swallowed bills inside the box even if there's no plan to ever break the box open. But there's also value to the bills the box will generate in the future, although nobody knows exactly how much that will be. There's also value in knowing that all or part of the 30% can be re-sold at any time to anyone. There's value in knowing your ownership interest is secure, legally protected. And there's value in being confident that the box indeed is as represented, that you have all the basic information you need. Given all that, it's worth some premium above the bills inside the box, and that value fluctuates mainly based on different people's view of the value of the future unpredictable stream of cash. People write books about it. Analysts analyze it to death. Newspapers write articles about it. Everybody's got an opinion. The opinion changes if the box seems to show a change in its behavior. Or sometimes the opinion changes for no reason at all. It's just that the old opinion became unfashionable.

So. The bills are the net profit. The re-swallowed bills are retained earnings. The bills it leaves on the table are dividends. The bishops and Nobel prize winners are accountants, auditors, lawyers, trustees. The fact that ownership can be easily bought & sold is liquidity. The information is reliable and widely distributed. The legal system is sound. And the future is unpredictable. No wonder the price fluctuates.

But there indeed is real value to that 30% ownership. I's not a con or a Ponzi scheme.
posted by mono blanco at 2:48 AM on February 4, 2005 [1 favorite]

That's a good point, mono blanco, and I would distinguish between a "Ponzi scheme" and a "pyramid scheme" by saying that--in my mind, at least--a "Ponzi scheme" is an intentional mechanism to defraud, while a "pyramid scheme" is more of a description. It's just a model where successive ranks of investors end up capitalizing their own personal gains by selling off to later, usually larger groups, and each successive group takes a bit of a hit for coming into the game later. (I know it's not that orderly, but still.) Factors like growth in share value mean that it's not necessarily a losing proposition for any given rank of investors, but there is a kind of rolling swap that occasionally burns out, leaving nth-generation investors holding the bag after the initial folks are long gone with their profits.

So, when I said I agreed it was a "pyramid scheme", I wasn't saying it's systemic fraud, but just that it's an apt description of the model.
posted by LairBob at 4:45 AM on February 4, 2005

LairBob -- the difference, I think, is that a pyramid scheme has no economic engine except for the capital contributions of the future dupes. I put $10 in, then I get 10 more people to put $10 in, etc. As long as we can find people to put $10 in, the pot keeps getting bigger.

Shares have an underlying economic engine in that the company itself becomes more valuable by producing products/services that people want to buy. Thus, even if nobody puts another $10 in, the shares can increase in value because the company itself is creating economic value that did not exist before.

The DJIA has gone up over 150 years or whatever not just because more and more people want to put $10 in (though this is part of it), but because the companies actually create more economic value today than they did in the past.
posted by Mid at 6:25 AM on February 4, 2005

Also, ponzi schemes are pyramid schemes; so says the SEC.
posted by Mid at 6:27 AM on February 4, 2005

Speaking from the perspective of a fixed-income, not an equity guy, I think a lot of the dispute over the centrality of future dividends to valuation can be resolved by recognizing that, as a metric of valuation, it is appropriate to think of dividends as meaning "dividends and distributions." Distributions are what occurs when a company liquidates, or is taken over.

No stock -- not even Google -- would ever be worth anything, or could be worth anything, but for the expectation (and legal claim) of eventually receiving liquid distributions, just like a $20 bill could never be worth anything but for the expectation it could be swapped for consummable goods and services.

And, just like you might hold onto a $20 bill for 50 years without spending it, relying all the time on the ability to spend if you chose, Google might not actually have a liquid distribution for 25 years. That doesn't change the underlying reliance. If the market ever became persuaded that Google could never pay a dividend or sell its assets for distributable liquid cash or securities after satisfying senior obligation, the market price of the stock would go to zero.

The reason why we don't actually run dividend discount model valuations on companies like Google is that we don't have the information to do so without an unacceptable degree of speculation. We use other methods (of which there are many, and some of which were quite capably described above) instead, not because they are theoretically superior, but because they happen to employ information inputs which are available to us.
posted by MattD at 7:47 AM on February 4, 2005

MattD nailed it. Tirade's comments are reconciled to the other comments in the thread if you substitute "dividend" for "potential future dividends and/or future distributions."
posted by Mid at 7:59 AM on February 4, 2005

“Large” institutional investors -- a category including all managers with at least $100 million under management -- nearly doubled their share of the common stock market from 1980 to 1996.

The classic book (one that predicted this phenomen) is "The Unseen Revolution: How Pension Fund Socialism Came to America", by Peter Drucker, published in 1976.

This is also why it's generall Not a Good Thing [tm] to spend a lot of time obsessing over individual stocks to buy or sell - the vast majority of folks doing buying and selling do so for a living (as a money manager, professional investor, etc.)
posted by WestCoaster at 1:40 PM on February 4, 2005