Why are stocks valuable?

[iron81]

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Ok, I think I understand the future dividend arguments. So let me ask this: when you buy a stock, does the money you expect to gain through dividends + the money that future owners expect to gain through future dividends justify current stock prices?

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In theory. The market believes they do. If you don't, short the market, buy gold/bonds/whatever and good luck.

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Hey, I have no problem owning stocks. They may be a gamble, but they are an ev+ gamble. It just seems that the average dividend paid is so small compared to the average stock price.

[Brainwalter]

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Ok, I think I understand the future dividend arguments. So let me ask this: when you buy a stock, does the money you expect to gain through dividends + the money that future owners expect to gain through future dividends justify current stock prices?

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In theory. The market believes they do. If you don't, short the market, buy gold/bonds/whatever and good luck.

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Hey, I have no problem owning stocks. They may be a gamble, but they are an ev+ gamble. It just seems that the average dividend paid is so small compared to the average stock price.

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Whether they are currently +ev or not depends on the answer to the question you posed.

If you assume that they are +ev, then the answer to your question is "yes."

[DesertCat]

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Ok, I think I understand the future dividend arguments. So let me ask this: when you buy a stock, does the money you expect to gain through dividends + the money that future owners expect to gain through future dividends justify current stock prices? Oh, and don't think that an organization can't exist if it is a money "black hole". Pyramid schemes are an example of this.

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Pyramid schemes can't last for long. Google DCF, it describes how to value a stream of future cash flows, it's essentially how most public companies are valued.

Essentially, stocks are worth the stream of future "owner earnings" that can be reasonably expected from them. Owner earnings are the profits left over after paying for the firms capital needs. I.e. Ford may have a good year and report record profits, but to stay in business some of those profits may be required to maintain factories to stay competitive.

And having management reinvest the remaining owner earnings is only good if they are reinvested at a high rate of return, otherwise the company is trapping your earnings in a low return endeavors. You have to consider not just how profitable the business is, how profitable it will be in the future, the likelyhood of potential risks that would hurt that profitability, but also how likely those profits will be reinvested effectively or returned to shareholders.

Valuing your own wholly owned business isn't simple, but there are extra layers of complexity for a minority shareholder in a public company.

[hawk59]

Iron,

If company XYZ is earning $2/sh, and they pay out no dividends, and the stock is trading for $6/sh in the market then someone can come along and buy the whole company and now they will actuallly be receiving the cash. And an investor can look at XYZ and say "This is cheap and it makes sense that someone will come along and buy the whole company at a big premium to the current price." And so the price of the stock would go up until people figured it was about fairly valued based on a DCF. The future dividend model is the theoretical thing people talk about, but I think the prospect of having the entire company bought out is a more practical explanation.

[maxtower]

Obviously some stocks are overpriced and some are underpriced in the market. Because its so difficult to value a stock, these inefficiencies exist. You would make a mistake to buy a stock that was overvalued. The trouble is that it is difficult to know with certainty what the value should be. Mutual funds help to resolve this problem by averaging out the over valued ones with the undervalued ones giving you a return somewhat close to the productivity gains and growth of the economy.
Think about it this way with a oversimplified example. Suppose you bought a company for $20, and that company made $1 in profit each year reliably. You aren't just buying today's earnings, but also future earnings less the inflation rate. Suppose inflation is 5%.
This year you get $1 next year, its $1 - 5% adjusting for inflation.
2006 - $1
2007 - $0.95
2008 - $0.9025
2009 - $0.8574
2010 - $0.8145
...
2077 - $0.0276

If you add all these returns up, the total is around $18.50, and the return stays pretty flat after that. This means you have unfortunately overpaid for the stock, since the next buyer would probably like to pay a price closer to $18.50. However if you can factor in a little growth in profitability, then the stock looks like a steal, because not only does it return $1 each year, but also a little extra from the growth of the company or increased efficiency. Factor in a negative growth rate, like a company which is losing market share, and the real value decreases. Hope this helps and doesn't add to the confusion.

[Groty]

Pull a dollar bill out of your wallet and ask yourself why people are willing to sell you valuable goods or perform services that you need for that piece of paper.

[Esection]

I think you guys are all on par with this, but are missing a few important aspects (and if I repeat anything previously said I apologize).

First of all, there's the concept of the Present Value versus Future Value of money. That is, a dollar today is worth more than a dollar 5 yrs from now (minus inflation), because it can be invested at x rate of return (which compounds).

Second is the fact that analysts derive their estimate of a fair price for the stock etc based on the company's present and future cash flows. They look not only at what revenues and sources of income the company has now, but next year and the year after and so on.

And, as you probably know, the current price of a stock is a function of supply and demand in the marketplace. This supply and demand is the # of people who want to sell/buy etc (simplified of course).

This demand and supply is created by what people think the value of the stock (and therefore the comapny) is. A stock is not a derivitive security. It is a share of ownership in the company.

That is the utility - a share of ownership in the future cashflows of a particular company.

Now, if you equate dividends granted or yield with utility for stocks, then buy a security that has a high yield - lots of oil/gas partnerships etc and DRIPs will offer you this.

However, like it was mentioned above, the reason many companies do not offer large dividends is because they choose to reinvest that cash back into the company - which, should therefore make you stock more valuable (because it has a greater more positive flow.)

sorry if this was a bit wandering...

[iron81]

Hawk wins the most plausible answer/answer I understood award. Unfortunately, there is no prize, but I'm sure the thanks of an anonymous internet personality is prize enough. Thanks all.

[GeorgeF]

1) Dividends
2) You can sell for more $$$ to someone else
3) The company will be purchased whole for more $$$ than you paid
4) All the cool kids are buying shares.
5) No choice (IRA investing for example)

[LinusKS]

The interesting thing about the stock market, is that at one time companies paid more in dividends, than what they paid as interest on their bonds. So if interest rates were going at, say 6%, dividends would be set at least as high.

The theory was that stocks were more speculative, so they had to pay at least as much as bonds, to attract investors.

That was decades ago, of course.

Since then, dividend yeilds have gone as low as 1% (I don't know how much they've gone up since then). Investors no longer care about dividends, because they know stock prices will go up, because that's what they've done in the past.

In other words, because you could have made a lot of money in the past, by buying low (when dividend-yields were high) and selling high (now that yields are low), you're therefore destined to make money by buying high (now), and hoping that stocks will go even higher.

Silly, isn't it?