The value of Stocks

[jefipius]

All,

This may seem like an awfully naive question, but can anyone tell me why stocks have any value at all? If for example, a company pays no dividend (I.E no profit sharing) why do the earnings of a company have ANY effect on share price. I know that stock represents 'ownership' in a company, but in reality what does this amount to once the company can be more or less sure of 51% of its votes?

It seems in a way just a ponzi scheme - hope to get in early and hope that someone else buys you out higher. Am I crazy or just missing something (or both!)

[BigMoneyJim]

I am also fairly naive, and sometimes I lose track of what real value stocks represent.

Here's my best shot:

Stocks represent investment and part ownership in the company. The company is legally responsible to you in some ways. Furthermore, the people controlling >51% of the company have a vested interest in increasing the value of that stock, especially when it pays them no dividends.

If the liquidation value of the company is greater than the current price of all outstanding shares and it doesn't look like the company will grow or support dividends, the company could liquidate and compensate shareholders that way. I don't know if that's ever happened, but it would seem to put a floor on the difference between perceived value and liquidation value. (Of course a company's "real" value can drop to near zero in a big hurry; we have seen that happen before.) I understand a mechanism similar to what I described keeps ETF's prices in line with their NAV.

But in practice it does feel like paying money for paper with speculation that someone else will pay more for it later. And from my point of view, day trading is exactly that and more of a gamble than an investment. Longer term holding feels more like investing to me.

If you question stocks, then you might question bonds, too. After all, you are giving someone money for a promise that they will pay it back--if they don't go bankrupt. And bonds are traded around before maturity, so you can speculate on bonds as well as stocks.

In other words, if we don't trust in owning a piece of the company for dividends and/or value/price appreciation, then why would we trust loaning come the same companies money? (Of course you can buy government bonds and ignore companies altogether if you want.)

I figure it's all better than hiding it in the mattress, because everyone knows to look in the mattress. (Remember when you were a kid and thought that was the most ingenious place to hide something? )

[Nords]

The price of gold has been rising like crazy over the last three years-- but mostly for those who use American dollars. Gold's price rise is partly due to the dollar's drop in value. There are a lot of other factors and not a small amount of manipulation, but gold's rise has been helped by the dollar's fall.

And the same may be true of stocks. They're only worth what you think someone else would pay for them (the "Greater Fool Theory") or worth the money that would be acquired by the sale of their assets. (Book value, briefly known as the "Enron Theory".)

Bonds are only worth the credibility of their lenders, as many Latin America investors have spent the last century-and-a-half affirming.

CDs are only worth what the FDIC & NCUA will pay for them. Even pensions are only good for the PBGC's float, and it's not as robust as it used to be.

And us military/civil-service retirees are dependent on the rest of the world's willingness to keep gorging down more Treasuries. Presumably the same is happening with Social Security.

None of these things have any value without society's legal support and regular audits/publicity.

You want security, reliability, & liquidity? I guess it only comes from gold/silver bullion or from running your OWN business (especially if you can issue stock!).

If you're willing to take on more risk you might work up to T-bills or CDs, which would put your risk profile right up there with Depression survivors. If a company goes under, bondholders are at least paid before stockholders. Any risk after that has to be offset by Ben Graham's "margin of safety".

It's not very cheery, but it's realistic.

[cute fuzzy bunny]

There is real value and speculative value.

Real value is determined by drawing down the net present value of the companies future earnings, plus earnings growth potential, plus dividends, plus potential dividend growth. Real value is then tempered by the risk premium for that company, which is based on its likelihood to remain in business, continue earning and growing earnings, and continuing to pay and increase its dividend.

Clearly that isnt something easy to figure out, because some factors are variables, and you have to decide how many years out you're going to estimate future earnings.

Risk premium is also a treat to decide on.

Its easier to figure out for large stalwart companies with consistent track records, harder for "value" or small stocks because their future and risk premium are a small variant of "anyones guess", hence their higher returns when chosen in bulk (via index funds) to mitigate their inherent risks.

Then there is the speculative value, as in 'Hoo baby, we've got a company that is going to really grab eyeballs and establish our portal as the number one destination on the internet!!! Profit? Uhh...we're still working on that. First we're going to steal underwear, then something else will happen, then there'll be profit!" kinda stuff that happened in the late 90's.

As Nords said, with bonds its mostly the risk premium and the attendant interest rate that you would want to be paid to overcome that risk. Some speculation in terms of future interest rates and future risk factors changes the base value of what someone would buy that bond from you for, but its not as speculative as stocks. Probably because stocks are more complicated, a lot of people dont understand them, hence they're willing to spend more for them than they should.

Kinda weird, huh?

[unclemick]

In 'ancient days' it was book value as determined by the accounts. I'd have to look up the details but that was the accountants best shot if you liquidated the company - paid off all debts and sold the assets at fair market. Most stocks sell at various multiples of book. Geraldine Weiss and the late Ben Graham are often associated with this metric. Athough Geraldine bless her heart is a big fan of dividend trends as a key metric.

[haha]

Quote:

All, This may seem like an awfully naive question, but can anyone tell me why stocks have any value at all? If for example, a company pays no dividend (I.E no profit sharing) why do the earnings of a company have ANY effect on share price. I know that stock represents 'ownership' in a company, but in reality what does this amount to once the company can be more or less sure of 51% of its votes? It seems in a way just a ponzi scheme - hope to get in early and hope that someone else buys you out higher. Am I crazy or just missing something (or both!)

Jefi, I think you point to a very big question. I have spent 30 years trading in and out of stocks, not funds. I think many of them, even those selling at high prices, are in fact worthless. Or at least presumptively worthless. For example many large older corporations are so burdened by retiree costs that realistically they have no earnings. But that doesn't keep "investors" from speculating on what effect their reported earnings will have on other "investors". J.M. keynes famously said picking stocks is like picking the winner of a beauty contest to be judged by others. What you want is not necessarily the most beautiful woman (or stock) just the one likely to be preferred by the other judges. And in the case of stocks, it helps to stay a few but not too many steps ahead of the other players.

This is even true in the case of companies with high cash flow and a good dividend policy. As you point out, that policy can be changed by whoever controls the corporation, usually management.

If they don't need a high stock market valuation either for access to financing or to protect their jobs and perqs, they might just just let the price fall by being very conservative with earnings reporting. This might be to get a better estate valuation for older chareholders in a wealthy family. It might more frequently be to allow an advantageous management led LBO.

Stock valuation is a very soft thing, and it depends on the level of trust and speculative juice in the current crop of investors.

I think one of few non dividend paying stocks that I would even look at for a buy and hold investment would be Berkshire Hathaway. This is Because Warren Buffet is almost alone in the high evel of ethics he shows to shareholders.

Mikey

[cute fuzzy bunny]

Love the guy, the company and the stock. But every time I think about buying some, or even a fund with a major holding in BRK, I keep thinking that the two guys running it are not going to live forever, and when Warren goes, that stock will drop like a rock...no matter how many times he and charlie assure everyone that they have a system in place that will live on without them.

And he likes to eat those damn DQ burgers, which doesnt improve the situation...

[Michael]

Quote:

...can anyone tell me why stocks have any value at all? If for example, a company pays no dividend (I.E no profit sharing) why do the earnings of a company have ANY effect on share price.

The dividends are ultimately what determines the value. People can buy a diversified portfolio of stocks, and live on the dividends for life, since dividends generally grow to keep pace with inflation. Even companies that currently yield no dividends are expected to start paying dividends at some point in the future. They are valued based upon what people guess they will eventually pay.

[panhead]

Yup, I think Warren Buffet qualifies for the title of "Da Man". His ethics to shareholders and intelligence in investing put him above anyone else I can think of. But I share the same fear, I can't buy this stock because I fear what will happen when the 'oracle' is gone. The man is a genius and appears to be a gentlemen, and he certainly is a legend, but none of those things will let him live forever. I guess I'll have to stick to indexing ! It's kind of funny, during the dot com craze, I held a decent amount of tech, mainly in funds as I am too lazy to pick my own stocks, and I remember reading about how 'ol Warren just didn't understand the valuations on Tech, and refused to invest in it. I kept thinking to myself, 'yeah, that figures, old dude, he don't get it, it's different this time !' Man I ate my sneaker, sock, foot, and half my leg. Then I read more about Warren and found even more respect for the man. Hey, I was young, what did I know ?

-Pan-

[BigMoneyJim]

Quote:

. . . and I remember reading about how 'ol Warren just didn't understand the valuations on Tech, and refused to invest in it. I kept thinking to myself, 'yeah, that figures, old dude, he don't get it, it's different this time !'

It was funny how he acted when he he obtained Geico; they do a large portion of their business on the internet, and he made jokes along the lines of now being a "clicks 'n' bricks" company. (I think it was Geico he said this about...)

I agree about Warren's motal-ness and the concern about the future of BH after his passing. I've been wanting an A share of BH for five years, but I either didn't have enough or it was a majority of my portfolio's value. I'll probably stick with indexing for the forseable future; I was too lazy to invest in tech in the late 90's, and that turned out well for me!

[cute fuzzy bunny]

I owned an "A" share for a while, if for nothing else to make a xerox of the share and put it on the wall in my office.

I also owned four "B" shares after I sold the "A" share, thats not a bad way to wade in a little.

[charlie]

The concern expressed by TH and others about
the eventual demise of Warren Buffet highlights
an advantage of passive index investing .... elimination
of manager risk.

Cheers,

Charlie

[unclemick]

215 orangutans. Warren Buffett's talk - Appendix I of the 4th ed of Ben Graham's The Intelligent Investor kind of lays out the case indirectly(for me). Bernsteins - 15 Stock Diversification Myth is also good, one in six(ballpark in this study) odds of beating the S&P.

Soo - I bet roughly 20 to 80 (one in four with some ego involved). Ie. 80% passive balanced index and 20% value/div stocks. The 215 orangutans are still winning.

[Nords]

Geez, guys, I hope people aren't talking about us like this when WE'RE 73 years old. What about Charlie Munger? Kirk Kerkorian? Jack Welch? Rockefeller's example with the Standard Oil breakup?

Buffett may be a guru, but it's worth noting that NONE of the CEOs at his companies have left after selling. Lowenstein's book also points out how mesmerizing Buffett is with any group. I think he's doing a fine job of expressing his skills & views while training the next generation, and I think the people working for him are listening to him. I'm willing to believe that they're capable of executing for at least a year or two after he leaves.

Buffett & Munger have locked up the majority of their estates in foundations (in Buffett's case, with his wife first). The foundations are restricted from selling more than a fraction of the stock each year, so the float won't exactly improve after they're gone. Read up on Ajit Jain, Lou Simpson, and Richard Santulli. Buffett advises worrying about their health, not his. They're doing the grunt work, and Buffett is just adding a few homilies to the shareholder newsletters.

Buffett himself is incapable of doing anything beyond what he's already doing. Between investing and playing bridge, his brain will stay sharp for at least another decade. If his myelin sheaths get clotted from too many Gorat's steaks & hash browns, the word will spread long before his physician finds out. He'll be put on the sidelines before he can do any damage. In fact, I wonder how we can tell if that's not the case now?

So I'll give Berkshire another 10 years. It's 30% of the retirement portfolio now and in the next decade it might need a bit of rebalancing (or maybe not). As a mutual fund it's up >40% over cost basis, it's up 11% this year alone, its "expense ratio" for the last three years has been a couple of brokerage fees, its turnover has been zero, and its tax efficiency has been perfect. If Buffett wakes up dead one morning, then it's quite possible that we'll all be watching the share price crater. Unlike mutual funds, they won't have to worry about a run of redemptions or managers leaving for hedge funds. The drop could be as much as 25-30% while investors "vote" on Berkshire's future. But then I'm buying in and waiting for the weighing to begin. Maybe it's risky, maybe it's not. But with another 30% of the portfolio in Tweedy, Browne Global Value and the balance in index ETFs, we think we can tolerate the risk.

Thanks for listening, I think I'm done now...

[markplus4]

While my current portfolio is heavy with yield stocks, I don't agree that business value is totally a function of dividends. If managment of a given company is a good allocator of capital, I'm comfortable in accepting a low/nonexistent dividend allocation. Share buybacks, brand extensions, acquistions, new equipment investment, etc., may be preferable capital allocation decisions for shareholders vs. dividend distributions.

Having said that, there are many CEO's out there who are miserable at capital allocation, so you need to pick your spots.

[Michael]

Most companies issue very little in the way of dividends when they are new and growing fast. They plow their profits back into their business to make it grow larger. As they get to a certain size, their growth rate slows down. At this point, they usually start giving a dividend, which is much larger than they could have afforded when they were small. Investors know this, and price a growing, no dividend company with the expectation that the money being reinvested in the business will some day pay off in greater dividends. Not every small investor who buys a stock realizes all this, especially if they are new to investing, but this does not change the fact that the pros who handle most of the investment money in stocks invest with this understanding. No company would survive if the big money pros genuinely thought that the company would never return any money to investors.

[JWR1945]

Strictly as a conceptual point: a company can produce zero dividends for its entire existence and still be worth something. It could have value to an acquiring corporation, where it improves the profitability of the combined organization.

Think of it this way: sometimes a business will have a loss leader that attracts customers. Supermarkets and bars (e.g., ladies night) are examples.

Have fun.

John R.

[cute fuzzy bunny]

Yep, most tech companies never pay a dividend or much of one.

I think the last analysis showed that the investor was far better off with dividend paying stocks, particularly of the value variety, than with growth stocks...at every capitalization level. Companies "on top of their game" dont often last long and are hard to come by or find early enough in their cycle.

Dividend paying companies keep paying out though. And "value" companies are usually more beaten up by the market than is warranted. Both lead to good short and long term returns.

Can you guess I hold very little growth or blend funds/stocks?

Damn, another thing I'm going to miss after I get married...ladies night...

Oh well, I guess it'll always be ladies night at home...

Nords:
Regarding your point about the bad things that can happen to any investment.
A very good argument for divesification. (You'll never get rich from diversification, but since most folks are retired on this board it makes the most sense.
I am a reformed individual stock investor, and after years (I'm 68), of sometimes spectaculor profits, and an equal amount of mind numbing losses, I decided I couldn't take it anymore.
After the recent meltdown in the market, about a year ago, I decided that if I didn't want to end up as an incompetent bag boy, I switched my entire portfolio into 3 stages. (This is a system that I am sure most of the posters have seen).
When you have to start drawing your deferred funds and expecting them to last it is much different in reality than in theory.
I still have stocks, only now in diversified mutual funds.
About 30% of my total porfolio. About 35% is in CD's and I bonds. The other 35% is in TIPs and short term corporates. After what I consider to be an unjustified run up of any of my stock mutual funds, I take some off the table and and to my 2nd. portfolio. I recently did that with Reits, as they have went too far in my opinon.
Not all, but enough so I won't be kicking myself if they really tank.
Not very exciting, I'm sure, for the younger investors, but what I really like about this system, is that I can push forward the hopefully higher returns on stocks, and sell off my ultra conservative first, and helps to have the confidence to hang onto stocks a little longer.
What it really does for me is 8 hours of no stress sleep at night.
Regards Jim

[Michael]

Quote:

It could have value to an acquiring corporation...

In this case, the earnings of the acquired company are eventually paid out as dividends to the stockholders of the acquiring company. *One way or another, earnings are expected to one day be shared with the owners. Stocks are not just a Ponzi scheme, as suggested by the original poster's question.