Robuh (77.71)

Why the way you think about stocks may be wrong (Part 1)

September 26, 2009 – Comments (6) | RELATED TICKERS: SPY , QQQQ

This is the first in a series of blog posts that addresses the basics of investing in stocks as an asset class. I'll (try to) lead the articles towards the general conclusion that how most present day "investors" look at stocks is fundamentally flawed and how this may have unfortunate consequences soon. A lot of this is extremely basic and self-evident but I've found that a lot of people that "invest" on the stock market have not given these types of concepts proper attention.

First some shared assumptions:

1) All living things eventually die
Hopefully we can all agree on this

2) All companies eventually die
They may last many decades but eventually they will fall. They have a lifetime similar to living beings. Why they die is actually pretty simple: probability. In order for a company to survive a hundred years it requires many generations of managers to become good stewards of the company. It may take 10 successive batches of good managers/directors to keep a company going that long but it only takes 1 incompetent group (or even individual) to destroy everything. Eventually it will happen either through inaction or ill-advised action.

There are many ways companies can die, but let's assume that for the purposes of this basic discussion that a company simply ceases to exist where common shareholders receive nothing and all liquidated assets go to debt holders.

So, throughout the lifetime of a publically-traded company the following things happen:

1) There's an initial public offering where the company receives money from the public in exchange for ownership in the company (let's ignore things like secondary offerings and convertibles for now)
2) These shares are traded on an exchange for a limited time and at varying prices
3) The shares eventually become worthless when the company dies

So the obvious question is: Why should anyone purchase these stocks in the first place? The answer is: Dividends.

The shareholders purchase these stocks in exchange for a percentage of all profits that are made by the company. Because of assumption #2 we know that there will be a sum total of all dividends per share paid out in the lifetime of the company.

Let's talk about a fictional company YYZ that trades on a public exchange. We have a crystal ball and we know that YYZ will yield $1,000 in dividends per share over the lifetime of the company, let's say 20 years. So, given what we know we would pay anything under $1,000 for this stock during an IPO, right?

Well, not exactly. The "value" of money is dependent on time. Money, in an inflationary environment, decreases in value over time so $1,000 now is worth more than $1,000 20 years from now. So it's more accurate to say that:

The value of a stock is equal to the present value of all future dividends.

For YYZ (that lives for 20 years) the $1,000 of all future dividends may only be worth $400 in today's money. In order for a share to be worth purchasing it has to be sold below $400.

So, what should the share price be of a company that never issues a dividend? It should be $0.00. If a company grows to be an extremely profitable multi-billion dollar company that always reinvests earnings without ever issuing a dividend, the shares are worthless. Remember that, for now, we're in fantasy land where there are no greater fools and we have crystal balls.

In the next article I'll talk about risk and cows. Hopefully people will find this somewhat interesting as it all comes together.