Economics-understanding the stock market

[FulhamFan3]

I need to have some things cleared up about stock, dividends and earnings.

What incentive is there for me to buy a share of a company? Or probably what my real question is, what influences stock price?

If a company issues dividends then I understand somewhat. People are going to want to own stocks that issue a large dividend so the price goes up because people want to buy them.

What I don't understand is companies like Berkshire Hathaway or Google that don't issue dividends and don't intend to. At which point I am only buying stock to sell at a later date. So if a company that doesn't issue dividends is successful does the stock price go up because the net worth is higher? Or is the only reason a stock ever goes up due to trading?

I'll give an unrealistic example. I own a few shares of a company. The following year the company is worth twice as much as the year before. No shares are traded at all. Is my share worth twice as much?

A company always has earnings whether it's positive or negative but it doesn't always issue dividends. So why do people go nuts for a stock when they hear a good earnings report?

 

[russ_watters]

What incentive is there for me to buy a share of a company? Or probably what my real question is, what influences stock price?

A stock share is literally a share of ownership in the company, so the value of a share of stock is literally a piece of what people think the company is worth. If you tried to sell your house, your car, or a baseball card today, there is a certain price that the market for such things would support. So too for a stock price.

So if a company that doesn't issue dividends is successful does the stock price go up because the net worth is higher?

Yes.

Or is the only reason a stock ever goes up due to trading?

Trading is a way of saying buying/selling. Objects do not gain in value by being bought or sold, they gain in value because people want to buy them because they perceive their value to be higher.

I'll give an unrealistic example. I own a few shares of a company. The following year the company is worth twice as much as the year before. No shares are traded at all. Is my share worth twice as much?

That's a redundant question: the "worth" of a company is measured by it's share price. Your share is worth twice as much because the company is worth twice as much and vice versa.

A company always has earnings whether it's positive or negative but it doesn't always issue dividends. So why do people go nuts for a stock when they hear a good earnings report?

Earnings are a big determining factor in the health of a company. If a company earned twice (sold twice as many widgets, for example) as much this year as last year, then there'd be a good reason for people to be willing to pay twice as much for a share of ownership of that company.

 

[FulhamFan3]

Thanks Russ. In a sense I already new the answers to all those but when you read them it makes it clear. I'll ask another question.

Why would you want to buy stock into a very highly valued company? The giants like Wal-Mart, Coca-Cola, Microsoft, etc. I understand my money is 'safe' with them but they have little capacity to grow. In this case am I buying stock for the dividend? Then there are the giants like Berkshire and Google that don't offer a dividend at all. Why would I want to buy these companies when they are worth so much?

 

[russ_watters]

If you believe a company has little capacity to grow, you would not want to buy stock in it. Do you think Wal Mart, Coke, and MS have little capacity to grow? I don't...

Companies don't offer as much in the way of dividends as they used to, so I don't think dividends usually factor very heavily in the investment calculus these days.

 

[AsianSensationK]

I need to have some things cleared up about stock, dividends and earnings.

What incentive is there for me to buy a share of a company? Or probably what my real question is, what influences stock price?

Stock prices move and change based on the kind of models used to value companies, and the perception of the company in the market. Very generally, people move the stock prices of a company.

If a company issues dividends then I understand somewhat. People are going to want to own stocks that issue a large dividend so the price goes up because people want to buy them.

Not necessarily true. Sometimes if a company isn't keeping a substantial portion of its earnings, then that sends a signal that the company has very little opportunity for growth. That is to say, the company has fewer and fewer projects coming its way that will add to its overall value.

What I don't understand is companies like Berkshire Hathaway or Google that don't issue dividends and don't intend to. At which point I am only buying stock to sell at a later date. So if a company that doesn't issue dividends is successful does the stock price go up because the net worth is higher? Or is the only reason a stock ever goes up due to trading?

To answer the first question, yes. For the second, stocks can go up due to trading, but the better question to ask is what kind of cash flows a company can generate. There are techniques out there devoted to valuation of a company. If you haven't looked around, I'd suggest you do some research on these valuation techniques.

Here's an interesting page on the subject.

http://pages.stern.nyu.edu/~adamodar/

He has some decent things to say about finance and the markets in general (obvious given he's a finance professor). I'd pay close attention to the section on DCF modeling found in "topics" section under the heading "valuation." Of course, this page does assume a basic background in accounting and finance, so if you're not familiar start with the section labeled "background."

 

[EnumaElish]

You should also keep risk in your view. On average, higher the expected returns, higher the risk associated with them. Also, you should diversify to achieve the optimal risk vs. return combination.

 

[trueuniverse]

Investing has a lot of risk, so I recommend mutual funds. Diversifying your risk is the safest way to make money in the long run. Investment companies even say that the stock market is not a way to pay off your college loans, because it is always uncertain. Cramer from Mad Money says that if you don't have a couple hours a week to study each stock, you won't be able to keep up with the market.

 

[WhoWee]

Two years ago I would have said buy asset based securities...but now? I don't think anything is under-valued or secure...think income generating...utilities are always good.

 

[russ_watters]

By historical standards, the stock market is currently undervalued. Two years ago, I would not have said to buy asset based securities: a diversified stock portfolio (ie, an S&P index fund) is now and has been for decades, the best long term investment.

 

[WhoWee]

Undervalued?

As soon as someone pushes through a capital gains cut...expect the Dow to return to $4,500...where it belongs.

Make investments based upon income derived. If it takes 100 years to return your investment...it's a bad deal.

 

[russ_watters]

Undervalued?

Historically speaking, yes. The Q value of non-financial companies (market value vs asset value) is currently at about 67%. The historical average is about 75. The low during the early '80s bear market was around 25, the high during the internet boom was about 190.

 

[WhoWee]

You are correct.

However, historical comparisons of this type are misleading. You must factor in the recent trends of moving property, plant and equipment offshore...and buying components from those companies.

This structure allows for a much higher return on assets...historically speaking, apples to oranges.

 

[russ_watters]

However, historical comparisons of this type are misleading. You must factor in the recent trends of moving property, plant and equipment offshore...and buying components from those companies.

Money is money. If they sell off their assets, it shows up in the data I posted.

This structure allows for a much higher return on assets...

Doesn't that mean it is even more undervalued than I said?

 

[WhoWee]

No, it's not that simple. Market forces have forced CEO's to make poor long term decisions.

If our "US manufacturing" company no longer owns the factory that produces the component parts...only buys those parts and does final assembly here...their return on assets is different than if they had to spend hundreds of millions on the factory.

The ROI is better, but the manufacturer doesn't control the product. If the factory (and a Chinese factory would n e v e r do this) raises the price or dumps the components in Japan or Eastern Europe (creating a competitor - "knock offs") the "US manufacturing company" loses a substantial amount of future revenues and profits...happens all the time.

The market always prices based on future revenues and earnings...many are overvalued accordingly.

We need to own our (new and high tech) manufacturing plants and equipment. The market shouldn't penalize CEO's who understand the concept of "control your own destiny".

 

[CRGreathouse]

We need to own our (new and high tech) manufacturing plants and equipment. The market shouldn't penalize CEO's who understand the concept of "control your own destiny".

Some companies will choose to do so, and others won't. Investors will choose to put their money where they feel it will perform best, and long-term returns will reward those who chose properly. Isn't the market great?

 

[CRGreathouse]

I'll give an unrealistic example. I own a few shares of a company. The following year the company is worth twice as much as the year before. No shares are traded at all. Is my share worth twice as much?

Your shares are worth just as much as someone is willing to pay for them.

Let's say a company has assets valued at $15 per share and their stock is trading at $20 per share. You buy some shares and one year later, the company's assets are valued at $30 per share. The stock price could be anything -- it's just what someone would pay. Strong performance like that would probably send the price soaring, but maybe it won't for some reason.

But assets do provide a sort of anchor for the stock price: if a company is liquidated, its net assets (if positive) are distributed amongst the stockholders. So in the above example it would make sense for the new stock price to be at least $30. (If not, it could be a takeover target.)