Explaining why people theoretically buy and own stock in companies isn’t necessarily intuitive so why not try a simplified analogy?. I previously stated that stock is bought based on projections of the present value of its future earnings and assets, so let’s attempt to look at that in action.
The “Company”: For our example lets use an absurd example of a black box that randomly outputs dollar bills. I hypothetically own this black box (which represents a company), but I’m looking to get some cash up front instead of waiting for the money to come out. Instead, I want to sell to you, the investor, a one-half stake in the black box.
That one-half stake would be equivalent to one share out of a total of two shares. It could be represented as 50 shares out of 100 shares also, as it is all about percents; 50 in this case. So, I tell you, that share entitles you to 50 cents for every dollar that box prints out (equivalent to a stock’s dividend). How much would you pay for this box? You’d be crazy if you didn’t ask a few questions:
- How often does this thing spit out a dollar bill?
- Are there any costs associated?
- Is there a risk it stops producing these things?
- Is there a trend in production?
- And so on…
The Price: In answer to these questions, I provide you the applicable data. Let’s say you look it over and you decide it looks to you like it will produce 200 dollar bills this year, at which point (for simplicity sake in the example) it will stop producing all together. Well, it’s worth 100 dollars to you because you get half of those, right? If you think this is true, boy do I have some business deals I’d like to do with you!
If someone proposes that you give them $100 now and they will give you $100 back in half a year, that is a bad use of your money even if you are positive they will pay you back. You could surely get more money than that simply investing in low-risk bonds. So what is that time difference worth to you? In simple terms, it’s worth whatever you think you could make without the specific investment. If you make an average of ~6% annually investing your money, you would require similar terms on the loan (I’m ignoring risk and emotions here). A similar concept should be applied to our black box.
Keeping it very basic, we’ll say that the bills produced by the black box are going to come out on average six months after the investment. If you invested that money, let’s say you could have made 3% interest in that time span. Well, you better be able to make at least 3% on our black-box venture for you to even consider making the purchase. X*(1+0.03)=100. Turns out, you should buy that 50% stake in the company if I’m selling for less than $97.09.
In the stock market, everyone has different predictions on how many dollar bills a given company will produce (and when). That results in many different estimated prices for a stock. People buy the shares when they think it will produce more profit than the price indicates and vice versa. The price of the shares zeros in on the average.
The Result: Back to our example, let’s say that I’m selling for $90. There’s a sucker born every day, huh? You make the purchase and reap the benefits as the profits come in.
Wait, though! Many stocks don’t pay frequent dividends, and that money never seems to make it to the owners! What gives!
Well, here’s the thing… I’m running this black-box business, and I keep getting these dollar bills out, but I thought to myself “hey, instead of paying this out as dividends, why not buy more black boxes? It’s working well so far.” As long as that investment will still make you more money than other investments, you should actually want me to buy more boxes. If you liked this company making $100 per year, you’ll love it making $200 per year. So the money gets reinvested into the company. Eventually you’ll see the profits in the form of dividends, but why stop when you’ve got a good thing going?
Wrap-Up: So that is my example of what stock gets you. Changes in how much the company will make is what is supposed to change the price of the stock. If we find out that box is being more productive than we thought (or likely will be), the price of a share should go up, and vice versa. It shouldn’t go up simply because “this is a trend” or “they have a lot of users.” It should go up or down based on the money investors believe they will or will not make.
Now, I ignored a lot of factors (the biggest one being risk) and cut some corners, but hey, it was an example about a black box that magically produces currency… so back off!