The Stock Market and its Valuation

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 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.

There's nowhere I can't reach.

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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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.

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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 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?