The Stock Market and its Valuation

Something has been bothering me lately. I'm usually one to try to find answers by myself, but this is something I have not been able to figure out. Since it has the potential for sparking debate, the Political Palace's purpose, and might be a somewhat more "serious" subject, thus, in theory anyway, more suited for the Political Palace, I've decided to post it here instead of General Discussion. Here goes:

Originally, the stock market was created to allow the trading of securities, primarily in the form of shares in corporations. This much is still true today. However, back at its inception, the valuation of a particular share was essentially determined through the potential for return, not so much in raw profit from the corporation, but in the actual money it paid out to the corporation owner's, the shareholders; in other words dividends. So far so good, a share's price is determined by just how likely its owner is to get money out of it, and how much. The mechanisms of capital gains are easily enough derived from this, coupled with the laws of supply and demand: the more a share is likely to earn its owner, the more others will want it, and the higher the price to acquire it from someone who currently owns it. This much is perfectly understandable for me.

However, moving to a more modern setting, there is a fairly noticeable difference: quite a few corporations have decided to pay next to nothing in term of dividends to their owners, while a fair number of them have outright abolished the entire concept. Now this is where I seem to have trouble: where does the valuation of shares, or even more fundamentally, their intrinsic value come from? One could say that their valuation comes from the demand for the share by the market. Fair enough, but why would the market, or in other words, investors, want shares if the only reason they are valuable are because other investors want them? Since no dividends are paid, the corporation's performances have no direct effect on the share prices through the amount of dividends paid, and this cannot be used to determine a share's value. It seems to me that the only possible explanation is that the value of those shares depends merely on the will of "investors" to put their resources into concepts loosely tied to actual corporations and their creation of wealth, through the moods of the market and its perception of a particular corporation. If this is truly the case, then the stock market appears to me as a sort of grand casino where money can be extracted for the casino's, and the corporations', purposes, through initial public offerings, but never actually given back to those who invest at any particular moment in time.

Hopefully I'm wrong, after all I have no formal background in economics or finance, but I'd still like it if someone could tell me juste were does the value of a particular stock, fundamentally, comes from.

Jam it back in, in the dark.

I figured that the shares were determined by the net worth of the company's assets and their profits. Trading shares with the only incentive for buyers being speculation, though, is a shit way to encourage real investment.

There's nowhere I can't reach.

If you don't want to grab a book on the subject, I'll give you the instruction of the folks at the Wall Street Journal: http://www.smartmoney.com/university Check the valuation of stocks section in the main area, as well as "dividend" and "dividend/yield" in the glossary. I'd suggest an economics text, however, for a detailed explanation of the system, as it's somewhere between the 2 situations that you described.

How ya doing, buddy?

Broadly speaking, there are two components to a stock's valuation: its dividends, and capital appreciation potential. Basically, you buy stocks expecting either a steady dividend stream and/or expecting the stock price to go up. I imagine outside of fair value accounting (estimating how much the company is worth if you sell it now), every formula that prices a particular stock takes dividend yield and capital growth into consideration.

"Everything is worth what its purchaser will pay for" - Publilius Syrus

I am a dolphin, do you want me on your body?

Originally Posted by YeOldeButchere

One could say that their valuation comes from the demand for the share by the market. Fair enough, but why would the market, or in other words, investors, want shares if the only reason they are valuable are because other investors want them?

Greed. Returns have been consistently higher with stocks rather then bonds or other investment instruments. Or so we're all led to believe.

Every invester thinks he/she can win. Just like every gambler that enters a casino thinks they can win too. Some do, most don't.

That's irrational behavior. Even under the best of circumstances.

Originally Posted by YeOldeButchere

If this is truly the case, then the stock market appears to me as a sort of grand casino where money can be extracted for the casino's, and the corporations', purposes, through initial public offerings, but never actually given back to those who invest at any particular moment in time.

Someday I hope you'll realize how positively brilliant this observation is.

I was speaking idiomatically.

Originally Posted by Watts

Greed. Returns have been consistently higher with stocks rather then bonds or other investment instruments. Or so we're all led to believe.
Someday I hope you'll realize how positively brilliant this observation is.

Actually, as far as I'm aware derivatives have the highest rates of return. Equity has low profit margins and is where the "jocks" go after graduation.

Also, it's not nearly as irrational as you think. The problem with most investors is that they're stupid. The market is volatile, yes. However, when the market is in the shitter, you don't sell, you buy. It may seem couter-intuitive, but it makes sense. Similarly, people get emotionally attached to their investments even as it falls before their own eyes.

I'll admit, I have no experience trading. If you look at the top guys though, there's a reason they have Math and Physics PhD's. Read interviews, they all stress the importance of discipline.

How ya doing, buddy?

Yeah, but that doesn't explain the intrinsic value of stocks themselves when you don't actually get anything from owning it.

I figure it comes out of the future value expected of your share of the company if a person should ever need to buy up a buttload of stock to get them a worthwhile amount of shares in order to have a controlling amount of the company. I guess it's kinda like the futures market for corporate takeovers.

FELIPE NO

In addition to the potential of dividends, being bought out in a take-over, or having the original company buy back some stock, some stocks will give you some form of limited voting power on the direction of the company.

Unfortunately I have to agree though, the stock market feels more and more like an abstracted financial game. Instead of direct investments in projects, there's stocks, derivatives (bets how a stock will go), broken mortgages packaged into "securities", and other strange financial instruments. I forget what % of trading these days is derivatives and currencies but it's quite substantial.

Still, you're wrong to say "most don't win." Most people, just investing in a balanced way, have been able to win pretty well. You might argue they won't win in the future, for whatever reason.

What, you don't want my bikini-clad body?

Originally Posted by YeOldeButchere

Hopefully I'm wrong, after all I have no formal background in economics or finance, but I'd still like it if someone could tell me juste were does the value of a particular stock, fundamentally, comes from.

It has already been mentioned that one way to value the price of a share of stock is by calculating the present value of future dividends that the stock will return. Another way is by performing a valuation of the company and determine that how much the company is worth and then dividing it by the number of shares outstanding to arrive at the company's price per share.

Companies can choose either to issue dividends or aim for capital appreciation. By issuing dividends, companies are taking out a portion of their profits and returning it to their shareholders. When companies aim for capital appreciation, they're trying to invest their profits into future projects that will benefit the shareholders and making the shares more valuable that way. Both have the effect of making the shareholders more wealthy.

That's actually part of the reason why Warren Buffett chooses not to have Berkshire Hathaway pay dividends; he believes that he can get a higher return for shareholders by investing that money into different projects rather than returning it to the shareholder in the form of dividends.

As for generating a good return on one's investment through the stock market, let's just say this: the stock market is sort of like gambling, but it's structured in a way so that it's in the investor's favor. If you don't take much risk (like investing in penny stocks or emerging market stocks) and keep a balanced portfolio of large cap stocks (like the S&P 500), you would have been able to generate around an 8% annual compounded rate of return in the last 10 years (which includes the tech bubble and tech crash btw). In other words, you'd be able to double your money in 10 years. Much better than a bank CD, that's for sure.

Jam it back in, in the dark.

Originally Posted by nabhan

Actually, as far as I'm aware derivatives have the highest rates of return.

Playing in the futures markets does offer higher returns, but the trade-off is higher risks. Maximum risk for maximum reward. A really easy way to lose a lot of money if your instincts, or your Magic 8-ball are wrong.

There's also another little problem with derivatives....

Originally Posted by How Unfortunate

I forget what % of trading these days is derivatives and currencies but it's quite substantial.

I don't have exact figures either. Somewhere around a little over $7.5 trillion in real money controlling a little over $300 trillion in derivatives.......

Second thought, irrational isn't the word I'm looking for. Insanity is probably closer to the truth. It's a good thing most people are not paying attention.

Originally Posted by How Unfortunate

Still, you're wrong to say "most don't win." Most people, just investing in a balanced way, have been able to win pretty well. You might argue they won't win in the future, for whatever reason.

Does taking part in what feels like a abstract game that's probably rigged, and filled with shady players constitute winning? I think we've pretty much already lost at that point.

Regardless, that's essentially what I'm saying.

There's nowhere I can't reach.

Originally Posted by Watts

Does taking part in what feels like a abstract game that's probably rigged, and filled with shady players constitute winning? I think we've pretty much already lost at that point.

Regardless, that's essentially what I'm saying.

Someone correct me if I'm wrong, but I believe you've just committed the fallacy of equivocation. When How Unfortunate said that one could win by investing, he probably meant "receiving capital gains by putting one's money and setting up a balanced portfolio." Your "winning" has nothing to do with increasing the value of assets and everything to do with taking a moral high ground. And that's not what he meant at all.

While it is true that there are plenty of shady people ranging from those trading with insider information to brokers hawking shitty stocks to collect commissions, people should not let that stop them from investing in the market as a way to increase their capital. Just read some books on investing (A Random Walk on Wall Street is an excellent easy-to-read resource) and make sure you know what you're doing before putting your money to work.

This thing is sticky, and I don't like it. I don't appreciate it.

Originally Posted by zzeroparticle

When How Unfortunate said that one could win by investing, he probably meant "receiving capital gains by putting one's money and setting up a balanced portfolio."

Oh, no. We're talking about the same thing. The difference is he's using past tense and I'm speaking in broader future predictions. What goes up, will come down. So "winning" in the past is meaningless unless you're able to capitalize on your wins for the future. Otherwise, your win is pointless. With the way things currently are, I have ample reason to doubt most people can capitalize on the current state of the markets.

Other then learning from the past, the past serves no purpose because of ever changing market conditions. Even assumptions, like the Dow would never go down that seemed relatively sane up until last week, seem insane now.

Originally Posted by zzeroparticle

Your "winning" has nothing to do with increasing the value of assets and everything to do with taking a moral high ground. And that's not what he meant at all.

Morality has absolutely nothing to do with it. Nor does it matter. Only money, (and more importantly) making money does. While recognizing the conditions it is made under (casino analogy) and acting accordingly.

I am a dolphin, do you want me on your body?

While your statement that people can't really capitalize on current market conditions is true in the short-run, I don't agree with the long-term implications of it. When you start looking at the entire market (like the S&P 500) from a long time horizon (around 5-10 years) you can see that while individual years have different rates of return, overall, there's a trend going upwards which roughly runs out to about a 7.5% compounded annual rate of return. So unless your long-term outlook is extremely pessimistic, stocks are still a good place to put your money if your investment horizon is 5+ years. ETFs in particular are really good because they give you diversification from the get-go, which means you don't have to amass a large amount of money in order to obtain diversification to lower your volatility.

Of course, if your horizon is much shorter (1-4 years) and you want guaranteed capital at the end of the investment term, stick with US Treasury bonds which are very low-risk (and accordingly, offer lower returns).

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I think he's saying that at some point in the future the stock market will crash down completely and be worth nothing. Of course, I have to wonder how at that point any money would be worth anything since it seems the only way that would happen is in a globally catastrophic event where the fundamentals of our society are destroyed.

Or we all suddenly become communists, I guess.

What kind of toxic man-thing is happening now?

Originally Posted by RacinReaver

I think he's saying that at some point in the future the stock market will crash down completely and be worth nothing.

I wouldn't go that far, but unfortunately I don't have to be that vague with what might cause a stock market crash. A panic sell-off in derivative markets could easily spark a global economic catastrophe. It's unlikely but possible. Barring that possibility there's still plenty to be pessimistic about.

All that's happening right now is a education in sub-prime mortgages and the yen carry trade. Who knows how it's going to turn out but things do not look good.

FELIPE NO

So then where should one be putting their money these days?

What, you don't want my bikini-clad body?

Originally Posted by How Unfortunate

So then where should one be putting their money these days?

Gold bars, I suppose, though in the post-apocalyptic future gold probably won't have that much value. Just start stockpilling barrels of oil and derived product. You'll need it to power your rusted death-dealing car.

Anyhow, I'm actually happy with the response to this thread so far. I'll have to admit I was somewhat drunk when I made it, as I am right now, but what I was wondering are legitimate questions I'd been trying to answer for some time. One of the possible explanations for the valuation of stocks I'd thought of but left out on purpose in my original post was that of the actual power ownership of a company gives in term of choosing its top executives. I really wasn't entirely sure this was a valid justification, but now that some people have suggested the same on their own, it becomes more plausible as an answer.

Anyhow, please keep it up, the discussion so far is really insteresting.

Jam it back in, in the dark.

Originally Posted by How Unfortunate

So then where should one be putting their money these days?

That depends entirely on what your future goals are and the time horizon for your investments. If you are planning to retire within 5-10 years or are looking to use that money within that time span, I'd suggest a good mix of stocks and bonds with a greater leaning towards bonds the closer you are to the end of the time horizon because you want that guaranteed flow of income without facing a large amount of risk.

Of course, if your time span is longer, you can subject yourself to more risk because a loss won't hit you nearly as hard; although it hurts, you can make it up and aren't nearly as screwed as someone who is 2 years away from retirement and lost all of his savings in a big crash. With a long time span in mind, I'd suggest focusing on stocks since those have the greatest growth potential over the long haul without subjecting yourself to too much risk. Of course you can always take on more risk if that's your style, but I assume people will generally prefer steady growth over chaotic ups and downs (although I'll add that bandwagon effects do form when stocks get hyped up. Case in point: the dot-com bubble in the late 90s.)

So for most people here (who I presume are in their early or late 20s), I'd suggest going for a well-diversified portfolio made up of stocks. For those of us (like myself) who can't afford to buy 10 different stocks to stay diversified in order to lower one's volatility, there are ETFs and mutual funds that one can purchase in order to get that diversification. While this is by no means a get-rich-quick scheme, it's a surefire way to become modestly wealthy.

Originally Posted by YeOldeButchere

One of the possible explanations for the valuation of stocks I'd thought of but left out on purpose in my original post was that of the actual power ownership of a company gives in term of choosing its top executives. I really wasn't entirely sure this was a valid justification, but now that some people have suggested the same on their own, it becomes more plausible as an answer.

I'd argue that the valuation of stocks comes from the future returns that the company can provide to each shareholder. If the company makes more money, the individual portion of the company that one owns as stocks is worth more.

An example: let's say you have a company that has $100 in assets and you purchase 1 share of stock valued at $1 per share (100 shares outstanding) and that company is expected to make $10 in profit. The return to each share of stock would be 10 cents and people would be willing to buy and sell the stock at $1.10 because that's the expected worth of the company. So now forecast the future earnings of the company out 5 more years and now you're starting to get closer to the method that finance professionals use to evaluate the value of a share of stock.

There's nowhere I can't reach.

I think the question is, where does the desire to own 1 millionth of a percent of a company that's profitable come from (especially if they don't pay out dividends to shareholders)?

I still figure it comes from the hope that in the future there will be some massive buyback by the company or an attempt from another company to purchase large amounts of shares in order to obtain an actually worthwhile number of votes from their shares.

This thing is sticky, and I don't like it. I don't appreciate it.

Or some people do it so they're allowed to go to the shareholder's meeting. If I had the money, I'd buy a share of Berkshire Hathaway Class A shares just to be able to go to the meeting and listen to Warren Buffett talk for a few hours.

I am a dolphin, do you want me on your body?

Every time you mention Warren Buffett I think if Wilford Brimley and I just wonder why you'd want to listen to some guy talk about diabetes.

I was speaking idiomatically.

The Good
1) He's a sea of knowledge about investing and I'd like to listen to his outlook on the future of the world economy.
2) He writes the best annual reports that I've ever read. He's willing to admit when his investments and purchases are doing poorly and he's pretty honest about things.
3) He says things like "At 76, I feel terrific and, according to all measurable indicators, am in excellent health. It's amazing what Cherry Coke and hamburgers will do for a fellow." (Yes, the second richest person in the US is a fanatic for Cherry Coke.)

The Bad
1) He's a Geico fanboy, possibly because the company he manages owns Geico.
Corollary to 1): Actually, he's a fanboy about everything Berkshire owns. Berkshire's annual report pretty much gives off that impression.

What kind of toxic man-thing is happening now?

Originally Posted by How Unfortunate

So then where should one be putting their money these days?

Your guess would be as good as mine. That's what the state of things has been reduced to. It might work, it might not.

Originally Posted by YeOldeButchere

Gold bars, I suppose,

Wouldn't recommend bars. They're too much of a pain to sell. Since it has to be certified what purity of the bar is actual gold. Minted bullion coins are easier to sell/unload/trade with. Speaking for barter purposes only, silver would probably be best.

But eh, the price of gold could easily go down to 400 USD a ounce, (maybe 300 USD) just as easily as it could go up to 800 USD and beyond. Nobody's gone broke holding gold as opposed to paper though.

How ya doing, buddy?

Now now, you don't have to physically take possession of the bullion, do you? Not with these services floating about!

What, you don't want my bikini-clad body?