I think this is actually the answer to my questions earlier in the thread, share prices are coupled to the earnings of the company by the possibility that some one will try and buy the entire company in the future, rather then the day-to-day tradings of a couple shares.
Yes but misses the point.
Say you want to start a company with $1000. I buy $100 of stock. I now own 10% of your company. Depending on the stock this may give me some value such as voting rights or dividends but let’s ignore those for now (not all stocks have that anyway).
A year from now you have grown your company to $2000 in value. I STILL own 10% so, my stock is now worth $200.
In theory you might say that is because someone could, in theory, buy the company for $2000. This is not necessarily true. Someone else may come along and offer to buy for $1500 and if the majority of shareholders agree to cash out at that price then that is that.
My stock is now worth $200 because there is a belief out there that is its value. But in the end it is a belief. It is really only worth what others are willing to pay for it. Seeing as how the company doubled its value in one year people may think that performance will continue and may pay MORE than $200 (we saw this in the dotcom bubble…market capitalization of some stocks was absurd…far beyond the book value of the company underlying the stock).
Bottom line is the value is what people think it is. It is not a ponzi scheme because wealth can be created. Maybe the company I invested in was a mining concern and a day later they discover a huge gold pile underground. Lucky me. The company is now, quite literally, worth more than when I bought the stock. The actual value of the company is of course attempted to be discerned to appropriately price the stock but that is not always so easy to do and certainly not the final arbiter of price (again see Dotcom bubble).
As for the dividend return just think of a stock as a sort of a loan to the company. The company sells stock to raise cash to do stuff. You give them that money, they offer terms for that use which may include some dividend…or not. Crappy dividend or not you always have the underlying security which you can sell. Hopefully it goes up. If it goes down bad luck. That is the risk you take.
With stocks, there is a concept called “valuation”. Basically, it’s an attempt to determine how much a particular company is worth, and by extension, how much the stock should be worth. There are a number of methods for doing this and it isn’t an exact science by any means. One method is calculating a discounted cash flow for the company. Basically, you attempt to predict how much money the company will make over its lifetime, factoring in risk and whatnot. Not to mention that the assets of the company (the building if they own it, the furniture and machinery, etc) all have a resale value. That’s why you rarely see a stock go to $0. At worst, someone can just come in and rip the copper wiring out of the walls and sell it.
A stock is inherently valuable because it represents a piece of the total value of a company, just as a deed represents ownership in a house. If the company is sold, you get a proportionate amount of money for it. If it’s bought by another company, your stock is exchanged for shares of the new company.
I’m sure there are. It’s not really my area of expertise though. I heard about one guy who is trying to model shareholder behavior after schools of fish and flocks of birds. Basically, it’s all very mathmatical.
The problem is with any of these models is that these guys look like geniuses up until the point where they don’t anymore.
The value of a stock is pretty obvious. It’s the value (market not book) of the assets minus the liabilities divided by the number of shares outstanding. Getting hung up over the fact that it may take time to realize that value is just confusing the issue.
Take an example of a private company. Let’s say I was the sole shareholder of an S-Corp that was in the oil and gas business. Let’s also say that I didn’t take any distributions from the company with the exception of those needed to pay for income taxes. How would I go about determining the value of my company? I certainly wouldn’t use some dividend discount model as we’ve already said, there aren’t distributions taken and so I would come up with a value of zero using that process. I would try to determine the net asset value of the company. If I had a reserve report that said that my oil and gas assets were worth $1 billion and I had $250 million in debt, I would place an approximate value of the company at $750 million. The fact that I am not taking money out of the company has no real impact on the value of my ownership.
Now, let’s say I decide I want to realize some of this value. I could of course sell the company or sell assets. I could also take the company public. I decide to sell 80% of the company’s stock through an initial public offering. Wouldn’t the 80% that ends up being owned by the public be worth around $600 million? Why would the fact that it is now publicly owned make the valuation process more difficult?
I guess that’s my question, then. How do we know a company is really worth $2000? Presumably, its worth what people are willing to pay for the stock times the number of shares of stock there are. But then that gets circular, people are willing to pay what the company is worth for the stock, and the stock is worth what people are willing to pay? At some point, someone needs to be able to get something out of owning the stock for its own sake, else I don’t really see
That’s my question though. How does finding a mine make the stock more valuable? If I own 1% of a company, and they find a mine worth a billion dollars, I can’t just give them my 1% worth of stocks and cart home 1% of a mine. At some point, owning a share of stock has to be coupled to the ability to do something with it. If I buy oil futures, and then sell them later at a profit, I know that somewhere down the line someone is actually going to buy the future not in anticipation of future profit, but becasue they want some oily black stuff delivered to their refinery. The future is coupled to some actual good or service, it’s hard to see how this is true of stocks.
Because when its privately owned I can realize the profits from it, as you said. I can pump that billion dollars of oil out of the ground, sell it to people, pay off my debts and pocket the 750 million.
But if its publicly owned, and I only own 1% of the company, and the company isn’t paying the profits out as a divident, I can’t do this. In theory, my share should be worth 7.5 million, but how does someone actually get at that money. Obviously there’s a way, since people do in fact buy stocks, I’m just trying to figure out what the mechanism is.
In my view, stock prices are irrational. Small events like delay of a product for 6 months can cause a stock to plummet, even though over the long term it is not important. The problem is that once one party acts irrationally, others are forced to follow. A couple of examples:
A mutual fund takes an aggressive stance and posts a large gain. Other fund managers look at that and attempt to keep up by being more aggressive than they would otherwise to make sure they don’t lose customers.
An employee of an investment bank takes some big risks that pay off. He is paid a large bonus based on the results, rather than looking at the risk/reward (which would be hard to determine in any case). Other employees are compared to this guy and either decide to do similar things themselves, or are urged to do so by management.
The only fix I can see is to encourage longer term thinking. Maybe bring back a true capital gains tax break that requires holding on to an investment longer, or tax bonuses at a much higher rate than salary. Even CEOs go for the home run these days, flitting around from company to company. They can come in, cut costs by laying people off, have the stock go up, and then be out of there by the time the consequences of their actions have an effect.
I think during the dot-com bubble there were lots of people who knew it was a sham, but they were basically forced to go along so as not to be left out. You just hope you jump off the bandwagon before it crashes.
Bottom line is a stock is worth what someone is willing to pay for it. That is true of just about anything.
If a company finds $1 billion dollars of oil today and the Apocalypse follows the next day the survivors sifting through the rubble will not give me so much as a cookie for that stock certificate. During the Dotcom bubble, where lots of money was chasing a few stocks perceived to be hot (everyone wanted in on the next Microsoft where secretaries became millionaires) stock valuations were just nuts (IIRC one new software company had a higher market cap than Xerox or IBM despite have a small office with 20 employees…or something crazy like that).
People buy the stock in the belief it will be more valuable down the road (forget short selling for the moment).
Now, when trying to ascertain whether a stock is a good deal or not a whole lot of things can come into it. You look at their accounting books for one thing (cash on hand, P&L, debts, assets, etc). You look at past performance. You assess the current economy and future performance (maybe they made a fortune making widgets but a new tech just came out that obsoletes widgets).
That and other assessments can be devilishly difficult to pin down and is where the art comes in. Financial accounting, despite standards, can be very complex and creative accounting can make books look very different from reality. Ascertaining the true value of a company is tough.
So we come back to what someone else is willing to pay for it as the bottom line that is presumably informed, to some extent, by the fiscal realities as best as can be determined.
Agreed, but in most things, there’s a fairly clear reason why someone would be willing to pay for an item. During the housing bubble, people were willing to pay irrational amounts of money for a house, but there still wasn’t much question as to what a house was for. At some point, everyone who was buying and trading and flipping houses had an understanding that houses were given value because at least some people wanted to live in them.
How do those things make a stock a good or bad deal. Why do I think someone would pay more for a company with a lot of assets then one with few assets.
This has nothing to do with market price though.
There are quite a number of discounted cash flow models that account for companies that are not expected to pay dividends. They do not return a zero value.
Using your example, if someone said that your company is worth $750 million long-term (with no plans for exploration), than I would determine how much the $750mm is worth today based on how much will be realized annually. The assets may be work $1b, but you may only be able to realize 10% of those annually, and this is a starting point for a discount model. If you are profitable, and are putting the money back into further exploration, valuation experts have models that hope to estimate how much in future oil and gas assets those reinvestments will uncover, and then they’ll start to discount that.
I guess the main point of my rambling (hope it isn’t too disjointed, but I keep getting interrupted) is that company value does not equal market price.
Market bubbles are driven by people - portfolio managers and traders mostly. When manager A finds a situation that lets him outperform on the short term, managers B to Z must also find a way to match, often by following A’s lead. Managers are rated on near term performance. Managers B to Z chase after manager A, and supply and demand start to take over. In the case of mortgages, more mortgages were needed than were available. Supply increased (but quality declined, though that was hidden by ineffective models and rating agencies) but not enough to match demand, so prices went up. As usually happens, some managers started taking negative bets that this couldn’t last, and then they get lauded for being “ahead of the market downturn”. Truth is, some bet on the downturn too early and get burned (margin calls and negative returns while market is rising), others hold on too long and get burned (don’t get to liquidate while still profitable), and some are just sheep drinking the analyst Kool-Aid.
P.S. to msmith: Companies do go to zero because shareholders are the last in line when assets are liquidated. The hope, as always, is that fixed assets can cover all debts, but that always isn’t the case.
The housing bubble occurred (at least in part) because a house is a tangible asset and even if someone defaulted on the loan the house could be re-possessed and sold to someone else. As such they were felt to be “safe” since, overall, there was not much chance for a great loss. There was also the belief that housing prices always rise over time (on the whole). As we clearly saw though what people were willing to pay for a house collapsed. As long as everyone agreed to keep paying more people kept making money but there is a limit and we found it the hard way. So, the house STILL has value, it is a tangible asset but you are the person out the $1 million for the loan and no one is willing to pay that. You now take a loss on that asset. Not a total loss but a significant one. Add that up across the nation and the problem is huge.
Because to you a tangible asset makes you safer as a shareholder and it does. To an extent.
If the company goes bankrupt the courts will start selling the assets and divide that up according to various rules. The more assets they can sell the more of your investment you may get back.
So, a software company which is valued at $1 billion but has nothing more than intellectual assets and an office with some chairs and some PCs has less assets than a mining company valued at $1 billion that has $350 million of mining equipment they can sell. (In theory the intellectual property is an asset and may be valuable and can be sold…just an example.)
Risk assessment is absolutely a part of buying a stock. There are high risk and low risk stocks. What you choose is up to you.
To compound the housing crisis, traders thought they had found a new way to mitigate risk across classes of mortgages, and that now these “safe” investments could outperform other safe investments. Once that started happening, the demand for mortgages grew, so more mortgage bankers started offering more mortgages and lowering the barriers to entry in the home ownership market. Mortgage bankers could then package and sell these mortgages quickly, so their risk was mitigated. With mortgages easier to come by, more people were buying houses. Demand went up, prices went up.
Just wanted to show some of the inter-relations that went into the housing / mortgage crisis.
Don’t think of the stock market as a bubble machine. Think of the stock market as the world’s largest casino and the only one that can legally operate in Manhattan.
When you bought 100 shares of stock in the 1920’s, you were buying a piece of paper. Nowadays even the paper is gone. You give money in exchange for something that’s purely abstract. The market price for this abstract thing sometimes goes up and sometimes goes down. As you’ve said, the up and down motion has very little to do with the company’s performance. This is especially true nowadays, when corporations do so much in secret.
So you can choose to invest money in these abstract things called stocks. Maybe you’ll make money. Maybe you’ll lose money. But you certainly should not listen to those people who say that you’re guaranteed to make money in the long run. In Japan, for example, the Nikkei is at 10,000 now. In 1990 it was at 40,000. If you’d invested in Japanese stocks back then, you’d have lost most of your money and never gotten it back. The same thing could very well happen to the American stock market over the next twenty years. (I’m not making a prediction, just saying that it’s possible.)
If you don’t like this particular game of chance, then put your money in bonds or commodities or CDs or a savings account.
What you are failing to understand is that the value is in fact more easily obtained when the company is publicly traded. You seem to think it’s the other way around. Let’s keep going with the oil company example. Sure, if I own the company I can produce the oil and sell it, but that might take decades. By owning a publicly traded piece of the company and there being an active secondary market to trade it, I can realize the value whenever I want. Your ownership becomes liquid.
Completely false. You ever heard of the concept of NAV. You don’t think that people try to determine a market value of the assets of a company to determine a true value of a stock.
No kidding, but I specifically mentioned a dividend discount model since the question was how dividends figure into the determination of a company’s value. A dividend discount model would give a company that paid no dividends a value of zero. Of course that model would be incorrect to use.
You are not understanding my statement. I said the company had a reserve report giving a value of $1 billion. How do you think that value is determined? The answer should be obvious; it’s by using a discounted cash flow model. That’s what a reserve report is. For oil and gas companies, this is in the footnote of their public filings. In fact, the SEC has a specific definition for how to calculate the reserve report value. You will often hear the term SEC PV10. This is using the SEC’s definition of proved reserves, the SEC’s determined commodity prices to use, and a discount rate of 10%.
This is incorrect; a company’s value is what someone will pay for it. What someone will pay for it is the market price.
I (think I) understand that. Certainly it’s easier to sell a share of stock then to go build an oil rig and pump oil out of the ground. But my point isn’t that one way is easier then the other, but that in the former case (the private owner) its pretty clear why he is able to make money, even if its more difficult. People want oil to fuel cars, he has oil, he can sell it to them and pocket the profits.
But in the latter case (selling stocks), even though its easy to do, its not clear why someone actually wants the stock. I want to sell it to make money, and maybe the person who buys it just wants to sell it later for even more money, but at some point that chain must have an endpoint. Someone somewhere must actually want 1% of an oil company so that they can…do what with it? Someone somewhere must be able to think they can take that 1% and actually make 7.5 million dollars with it in a way that doesn’t just involve passing the stock off to the next guy down the line.
FWIW, I still think my theory in #25 is the most likely explanation. That the 1% of stock has value because at some point Exxon Mobil or someone similar might want to buy my 1%, plus 50 other shares of similar size to gain a controlling share of the company so that they can actually go get that oil, sell it, and get control where the profits go. So while 1% of a company might be useless, I can buy it in anticipation that some entity will want to buy it (or some other individual will buy it in anticipation that some entity will want to buy it (or some indi…)) for more in order to gain control of the actual assets it represents.
You do realize that bonds trade in the secondary market just like stocks, don’t you? If you wanted to sell a bond, you would subject to many of the same things that affect equities. Also, commodities have the same volatility issues as stocks. As a general statement, you’re just as likely to lose money with commodities as you are with equities.
He doesn’t own oil. He owns a share of a company that owns oil. It just so happens that his share is 100% and there is no active secondary market for trading that ownership. At what point do you think the ownership of a company becomes worthless. Clearly you understand it has value when there is only one owner. You seem to think it has no real intrinsic value when it has thousands of owners. What about a company with 2, 10, 100, or 500 owners. Is there some point in your mind when it goes from having value to not having value?
Well, I work the financial services industry, having done time at hedge funds, asset managers and investment banks, so I hope so.
Certain dividend discount models would return 0, others would have a terminal value that can be discounted and would result in a non-zero value. Any dividend discount model, for your example, would likely undervalue the security.
I’m not an oil and gas man, and glossed over the words “reserve report”. I stand corrected and learned a little more about reserve reports today. This leads into the last statement.
I incorrectly accounted for the $1b reserve report as a sum of fixed assets. This caused me to think that you were equating the balance sheet to the stock price [(assets - liabilities)/shares outstanding = stock price]. I think we both agree that this isn’t the case.
Owning 100% of a company that owns oil seems a lot like owning the oil itself, though I guess maybe your better off tax-wise. But in both cases I can sell the oil, take the profits and either reinvest them or pocket them and swim around in the resulting money Scrooge McDuck style.
A minor point, but I don’t think its worthless. Again, obviously smart people are willing to buy stock, and I don’t think there deluded, so it must have some worth. I’m trying to figure out why it isn’t worthless.
I’d say it looses its intrinsic value once I’m left owning a piece that’s too small for me to be able to gain control of the profits from the underlying company (sell the oil, in our case). I guess exactly how many owners that would be would depend on how the governorship of the company was structured.