RSS feedThis blog has swung decidedly more technical in recent weeks and I think its about time to bring back a little focus on fundamentals.
Let me pose this simple question, “why are stocks valuable?” I would venture to guess that most people would answer one of three ways. 1.) I don’t know. 2.) Supply and demand. You buy because you think you can sell it later for more. 3.) Because it represents ownership in a company.
Stocks Have Underlying Value
The value of a stock is not simply in that they can be traded. If this were true, we might as well have big exchanges for baseball cards. The answer that a stock represents ownership in a company is slightly better, but does not quite get all the way to the bottom of the story. The key is what can be done with “ownership” in a company. Except in bankruptcy, owning stock does not give you a claim on anything the company owns. And, typically in bankruptcy, there are many other investors - those who loaned money to the company, preferred stock holders, etc. - who have claim to nearly anything of value in the company’s liquidation. Common stock holders really only have a residual claim on the company and this usually means - nada, zilch. This means that, for all intents and purposes, owning stock does not truly give you any right to any tangible value in the company.
So, why would anyone want to be a common stockholder. Part ownership has to have some perks, right? Well, common stockholders have voting power over how management manages the company. More specifically, it can tell management how to invest money the company has made. The most important result of this power is that common stock holders can demand a piece of the company’s earnings. This return of capital to shareholders is where the long term value of a stock is derived. How does a company’s management return earnings to shareholders? Easy, through dividends or through shareholder buybacks. I’m sure you’ve heard of these before.
Value = Return of Capital
Basically, the value of anything is derived from the cash you will receive from owning it. For something simple like an apple, it is how much you can sell that apple for. The cash generated from owning a stock is tied directly to a company’s earnings, but more specifically the portion of that earnings that you will end up getting. What about stocks that don’t have dividends and don’t have any buyback policies? Well, even those stocks trade on the assumption that, someday in the future, management will return earnings to shareholders. If there were no potential for a stock to return real cash to you, then it would be no better than a piece of paper. What’s more, everyone would know this and you wouldn’t even be able to trade it for profit. Don’t believe me? I’ve got stock for TheCuriousInvestor.com that I’m willing to sell you. Profits have doubled every month for the last three months. Your stock ownership gives you the right to brag about the site’s growth as if you had a part in it. But, management at TheCuriousInvestor has no intention of ever sharing a dime with shareholders. Are you interested?
All Companies Eventually Return Cash to Shareholders
So, when should a company return profits to share holders? View yourself as the owner of a company. If your business is profitable this year, you can do one of two things with the profits. You can take this money and put it in your pocket and decide to do something else with it. Or, you can take this money and reinvest it in your business. As long as your business is generating acceptable returns on the money you invest in it, you’ll probably be willing to keep reinvesting your profits. At some point, the returns on your reinvested profits will reach a point where you’d be better off take the money for yourself and investing it elsewhere. This is the same logic which goes on between all shareholders. While a company is growing and showing exponential growth in earnings, its worthwhile to save up retained earnings and reinvest. As growth slows, shareholders will clamor to get their rightful piece of the pie so that they can redeploy the capital elsewhere.
Practical Application
So, practical application. What does this mean to you? If you’re a short term trader. Nothing really. Just be glad that stocks have underlying value. Understand that ultimately market expectations and willingness to demand stocks that you trade are governed by growth expectations - primarily growth in earnings, but also secondarily growth in real return (through dividends or buybacks) to shareholders. For a long term investor, these principles underly the importance of profitability metrics like return on equity and return on invested capital especially for companies which do not currently pay dividends or have regular share buyback policies in place. It also makes a very strong case for concentrating your longterm investments on companies with dividend or buyback friendly policies as these will dictate continued share price performance.
