A few very basic investing theory questions that have bugged me lately

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A few very basic investing theory questions that have bugged me lately

Postby blaugranamd » Sat Jan 07, 2017 11:25 am

As I've pursued my "continuing financial education" over the last few weeks, a few questions have begun to perplex me and I'm hoping the Bogleheads may be able to shed some light on these for me:

1. If indices like the S&P 500 are selected by a committee based on requirements of fundamental analysis, then by extension aren't index funds that track the S&P 500 really just indirectly actively managed funds since the underlying index is actively managed?

2. What is it about a stock that gives it an intrinsic value? I understand the benefit if a stock is dividend paying, say like Johnson and Johnson or P&G. But why does a stock like Berkshire Hathaway have value? A few things: I get that it's fractional ownership in a company but why is owning part of that company valuable? Does a share of stock entitle someone to a fraction of the companies current total value? Sometimes it seems like stocks are nothing more than baseball cards with a particular company's name on them.

3. Why does any company care what the value of their outstanding shares are? By this I mean in an IPO the company brings in capital in exchange for selling some of it's company ownership to the public. But after that, the stock market is a secondary market that seems to correlate with company value/performance simply because we think it should. If tomorrow everyone in the world woke up and decided they wouldn't pay more than $1 for Apple stock, then the value of Apple stock would be $1 and billions of dollars would be lost. But that shouldn't affect Apple, they still have the same amount of physical and intellectual property assets, they are still bringing in profits, they haven't really lost anything other than being able to claim whatever fraction of ownership they retained as assets. So why does a company care what the current secondary market value of their shares are?

:sharebeer for any help understanding these things!
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Re: A few very basic investing theory questions that have bugged me lately

Postby nedsaid » Sat Jan 07, 2017 11:45 am

blaugranamd wrote:As I've pursued my "continuing financial education" over the last few weeks, a few questions have begun to perplex me and I'm hoping the Bogleheads may be able to shed some light on these for me:

1. If indices like the S&P 500 are selected by a committee based on requirements of fundamental analysis, then by extension aren't index funds that track the S&P 500 really just indirectly actively managed funds since the underlying index is actively managed?

Nedsaid: First of all, the expenses for index funds are very low. Even the Vanguard S&P 500 Investor shares have an expense ratio of 0.16%, Admiral shares are even cheaper. Second, the turnover of stocks in this index is also low, maybe 3% to 5% a year. Yes, a committee selects the stocks but it is a good representation of the market as a whole representing 500 stocks out of maybe 3,600 in the United States that trade and 70% or so of the market capitalization of the US Market.

Even a "Total Market" Index uses a form of stock selection. There are publicly traded stocks where the companies are so small and their shares so illiquid that a large index cannot effectively invest in them. Vanguard uses sampling to replicate the performance of micro-caps in the Total Market Index as it is impractical for such a fund to buy shares in all micro-cap stocks.


2. What is it about a stock that gives it an intrinsic value? I understand the benefit if a stock is dividend paying, say like Johnson and Johnson or P&G. But why does a stock like Berkshire Hathaway have value? A few things: I get that it's fractional ownership in a company but why is owning part of that company valuable? Does a share of stock entitle someone to a fraction of the companies current total value? Sometimes it seems like stocks are nothing more than baseball cards with a particular company's name on them.

Nedsaid: Stocks trade as a multiple of earnings. Historically, the US Market as a whole trades at a multiple of about 16. Companies that grow their earnings at a steady rate command higher multiples than companies with more volatile earnings. Faster growth commands higher multiples than slower growth. In extreme circumstances, where a company is very asset rich and earnings are very poor, a company might trade at liquidation value but this would be a sign of a very poorly run company.

Microsoft last traded at $62,84 but its book value is only about $9.10 a share. That is the market values the company at $53 a share more than what the accountants do. So the company is valued on the basis of its ability to generate and grow its cash flows and not on the value of its assets on the books. There is intangible value here that the accountants cannot capture.

Does this help?


3. Why does any company care what the value of their outstanding shares are? By this I mean in an IPO the company brings in capital in exchange for selling some of it's company ownership to the public. But after that, the stock market is a secondary market that seems to correlate with company value/performance simply because we think it should. If tomorrow everyone in the world woke up and decided they wouldn't pay more than $1 for Apple stock, then the value of Apple stock would be $1 and billions of dollars would be lost. But that shouldn't affect Apple, they still have the same amount of physical and intellectual property assets, they are still bringing in profits, they haven't really lost anything other than being able to claim whatever fraction of ownership they retained as assets. So why does a company care what the current secondary market value of their shares are?

Nedsaid: Market value is important. For one thing, the smaller your market value, the easier it is for someone else to buy your company lock, stock, and barrel.

:sharebeer for any help understanding these things!
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Re: A few very basic investing theory questions that have bugged me lately

Postby qwertyjazz » Sat Jan 07, 2017 11:52 am

1. Yes but it is really cheap
2. Someone could buy all the shares and liquidate the company - if it could no longer do so then the stock would be worthless
3. See 2
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Re: A few very basic investing theory questions that have bugged me lately

Postby TheTimeLord » Sat Jan 07, 2017 11:53 am

blaugranamd wrote:As I've pursued my "continuing financial education" over the last few weeks, a few questions have begun to perplex me and I'm hoping the Bogleheads may be able to shed some light on these for me:

1. If indices like the S&P 500 are selected by a committee based on requirements of fundamental analysis, then by extension aren't index funds that track the S&P 500 really just indirectly actively managed funds since the underlying index is actively managed?

I would agree that on some level indexes are very low volatility actively managed funds usually broadly diversified. What index funds don't do is try to pick winners and losers and churn their portfolios.

2. What is it about a stock that gives it an intrinsic value? I understand the benefit if a stock is dividend paying, say like Johnson and Johnson or P&G. But why does a stock like Berkshire Hathaway have value? A few things: I get that it's fractional ownership in a company but why is owning part of that company valuable? Does a share of stock entitle someone to a fraction of the companies current total value? Sometimes it seems like stocks are nothing more than baseball cards with a particular company's name on them.

The shareholders own the company, the company has value, your shares represents ownership of some portion of that value, it is that simple.

3. Why does any company care what the value of their outstanding shares are? By this I mean in an IPO the company brings in capital in exchange for selling some of it's company ownership to the public. But after that, the stock market is a secondary market that seems to correlate with company value/performance simply because we think it should. If tomorrow everyone in the world woke up and decided they wouldn't pay more than $1 for Apple stock, then the value of Apple stock would be $1 and billions of dollars would be lost. But that shouldn't affect Apple, they still have the same amount of physical and intellectual property assets, they are still bringing in profits, they haven't really lost anything other than being able to claim whatever fraction of ownership they retained as assets. So why does a company care what the current secondary market value of their shares are?

Well companies use stock options to compensate high value employees, they do secondary offerings of additional shares, And since the shareholders are the owners it is to the executives advantage to increase the value of the shares unless they want the owners to replace them.

:sharebeer for any help understanding these things!
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Re: A few very basic investing theory questions that have bugged me lately

Postby McGilicutty » Sat Jan 07, 2017 11:57 am

For number 3, most companies provide some type of stock-based compensation to upper management which gives management an incentive to care about the stock price. Also, companies sometimes raise money in secondary offerings (stock offerings after the IPO) at market price, so that is another reason to care about the stock price.

Further, some companies have huge cash hoards that help support the stock price. Apple's market capitalization is $628 billion, but they have over $200 billion in cash on hand. Apple has about 5.4 billion shares outstanding, so if it ever trades for a buck, you can kind of look at as paying $5.4 billion to get over $200 billion in cash plus a claim on future earnings.
Last edited by McGilicutty on Sat Jan 07, 2017 12:02 pm, edited 1 time in total.

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Re: A few very basic investing theory questions that have bugged me lately

Postby blaugranamd » Sat Jan 07, 2017 12:00 pm

Ned,

Thanks for the reply!

1. So the answer really is "sort of" active management. Just with virtually minimal activity.

2. I understand the P/E, P/BV, and all of that. But my question is WHY does any of that matter? If a companies profits double, why is the stock worth any more if the stockholders don't get any of that money? If I bought rookie NFL trading cards of Aaron Rodgers and Jason Campbell in 2005 the day they were drafted, the Rodgers card is worth a lot more because he's more famous and did better, but that's only because more people want it. If no one wanted it tomorrow, it would be intrinsically worthless. If I buy stock in Company A and Company B for $1 per share today in 10 years if company B has profits of 100x more than Company A but neither pay dividends, what makes Company B stock more valuable other than people assign it more value because we've all just accepted that, for no real reason other than we think company success should be tied to stock prices?


As far as ownership in the value of the company, I get that, but if I own, say 5% of all outstanding Apple shares, I can't just call up Apple and demand 5% of the current value of the company to cash-out my stock, yes?

3. I understand that concept of losing control of the company if a company has >50% of their outstanding shares publicly owned. But assuming there are not enough outstanding shares owned by someone other than the original company founds to lose control of the company, why would they care?
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Re: A few very basic investing theory questions that have bugged me lately

Postby avalpert » Sat Jan 07, 2017 12:04 pm

1. Indexes like the S&P 500 are not constructed based on fundamental analysis. They are selected based on at attempt to broadly reflect the total commercial landscape. That isn't to say they are the best way to do that - not when you can actually invest a total market index at the same cost as you can today. But it is not the same as active funds that are guessing on which companies will have better performance in the stock market.

2. Yes, the stock does entitled the owner to a fractional share in the current value. Now it isn't like they can just go and unilaterally take that share from the company - but it does mean that others are willing to pay them for the same claim on that fractional share.

3. The company cares because 'the company' is the set of owners of said stocks and (at least in theory) their goal is to maximize the value of that ownership. The questions of why should management care, or more accurately, how do we align hired management's incentives with 'the company' is a more interesting one and is why stock options are such a common feature in compensation packages today. Whether this has had the effect originally envisioned can be argued. Agency problems, in my experience, are at the root of the most vexing organizational challenges - both in the corporate world and public sector world.

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Re: A few very basic investing theory questions that have bugged me lately

Postby blaugranamd » Sat Jan 07, 2017 12:06 pm

McGilicutty wrote:Further, some companies have huge cash hoards that help support the stock price. Apple's market capitalization is $628 billion, but they have over $200 billion in cash on hand. Apple has about 5.4 billion shares outstanding, so if it ever trades for a buck, you can kind of look at as paying $5.4 billion to get over $200 billion in cash plus a claim on future earnings.


I get that, but that scenario only works if you can wrest control of the company and take the profits for yourself, absent that, those profits are just there and shareholders can't cash out their shares so short of controlling the cash reserves, what's the benefit? In other words, there's a lot of talk here of what a share entitles you to and what you own, but if you can't convert that ownership into cash outside of just selling it to someone else who's willing to buy it (say, if no one is buying nor selling), then you don't really have any tangible value.
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Re: A few very basic investing theory questions that have bugged me lately

Postby selters » Sat Jan 07, 2017 12:11 pm

If you rank all public companies by market cap, from largest to smallest, how far down the list would you have to go to find the smallest S&P 500 component? 600? 700? 1000?

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Re: A few very basic investing theory questions that have bugged me lately

Postby nisiprius » Sat Jan 07, 2017 12:13 pm

blaugranamd wrote:As I've pursued my "continuing financial education" over the last few weeks, a few questions have begun to perplex me and I'm hoping the Bogleheads may be able to shed some light on these for me:

1. If indices like the S&P 500 are selected by a committee based on requirements of fundamental analysis, then by extension aren't index funds that track the S&P 500 really just indirectly actively managed funds since the underlying index is actively managed?
Yes, but. With a very small "yes" and a very large "but."

Lately it's been fashionable for people who are attacking indexing in general to make much of the S&P 500 being human-selected. That's the "yes." The "but" is that it doesn't matter, much, and the proof is a comparison of a S&P 500 index fund (blue) with two large-cap index fund that are not actively selected (apart from human judgement of whether specific stocks meet the criteria for inclusion in borderline cases).

Blue, Vanguard 500 Index fund (S&P 500)
----about 500 "Leading companies in leading industries")
Orange, Vanguard Large-Cap Index Fund (CRSP US Large Cap Index)
----"U.S. companies that comprise the top 85% of investable market capitalization," about 609 stocks
Green, iShares Russell 1000 Index ETF (Russell 1000 index)
----The 1000 stocks with the largest capitalization

Three companies, three different indexes, three different selection criteria, same results. The difference hasn't mattered a tinker's damn.

Source
Image

In other words, unlike real actively managed funds, an S&P 500 fund is a quote-"actively managed" with no visible difference from a passively managed fund.

It's guff. It's a way to undercut passive investing by saying "Ha ha, you think your S&P 500 fund is passive, but it's not, so everything you believed was wrong." And my answer is "why do I care anyway, since I invest Vanguard Total Stock Market Index Fund, not the Vanguard 500 Index Fund." I guess it has a committee, too, but all the committee needs to decide is whether or not any given stock is part of the total stock market.
2. What is it about a stock that gives it an intrinsic value? I understand the benefit if a stock is dividend paying, say like Johnson and Johnson or P&G. But why does a stock like Berkshire Hathaway have value?
Yes, this puzzled me for a long time.

I am inclined to agree with those (notably including Jeremy Siegel, author of "stocks for the long run" that the intrinsic value is the present value (discounted) of the future stream of dividends. Period. End of story.

In the case of stocks that don't pay dividends, nobody likes to talk about it but everybody understand that that is a situation that can't continue forever. Shareholders will tolerate it while the company is in a growth phase, but when it matures they demand dividends. Thus, both Apple and Microsoft--while still highly successful--paid dividends once they "grew up."

I don't buy the "part ownership" idea, because it doesn't seem to me that you have any way to exercise it. You can of course regard the value of the company, or its earnings, or revenues, or whatever as a factor to consider in judging what stream of dividends it could afford to pay and thus perhaps what stream of dividends it will pay.

If you were certain that a company paid no dividends and never would pay them, then the mathematical value is the sum of an infinite number of zeros, which, like 0/0, is indeterminate.
Last edited by nisiprius on Sat Jan 07, 2017 12:26 pm, edited 3 times in total.
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Re: A few very basic investing theory questions that have bugged me lately

Postby alex_686 » Sat Jan 07, 2017 12:14 pm

As I've pursued my "continuing financial education" over the last few weeks, a few questions have begun to perplex me and I'm hoping the Bogleheads may be able to shed some light on these for me:

blaugranamd wrote:1. If indices like the S&P 500 are selected by a committee based on requirements of fundamental analysis, then by extension aren't index funds that track the S&P 500 really just indirectly actively managed funds since the underlying index is actively managed?


There is a mismatch between theory and reality. Lines are fuzzy, subjective judgement need to be made. How do you handle these things? I think he S&P's committee has a light touch. Sometimes it has 498 stocks, other times 502. A line needs to be drawn between large cap and small. Is 500 a bit arbitrary? Sure. However almost any line drawn through would be. What affect does this have? I would argue not much. I can't think of a case were the adjustment was not clearly laid out in the preexisting parameters. Take a look at the difference between the S&P 500 and the Dow Jones. The Dow Jones is much more subjective index.

blaugranamd wrote:2. What is it about a stock that gives it an intrinsic value? I understand the benefit if a stock is dividend paying, say like Johnson and Johnson or P&G. But why does a stock like Berkshire Hathaway have value?


It is not about dividends. It is about future cash flow to the owners. BH has value because it is assumed that it will cash flow in the future - dividends, stock buy backs, etc. This works because people believe that management can reinvest profits better than they can. You can search the forum for "Do Dividends Matter?" and come up with a dozen threads.

blaugranamd wrote:3. Why does any company care what the value of their outstanding shares are? By this I mean in an IPO the company brings in capital in exchange for selling some of it's company ownership to the public. But after that, the stock market is a secondary market that seems to correlate with company value/performance simply because we think it should.


Who is the company? I think the company is a abstract thing and does not have any feelings.

I think the people who own the company care about the stock value. They get to pick the CEO. If the CEO does not deliver the goods then the owners can fire him and hire somebody else. Or maybe some other company will pick up Apple for $1 and reap all of its profits.

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Re: A few very basic investing theory questions that have bugged me lately

Postby nedsaid » Sat Jan 07, 2017 12:14 pm

blaugranamd wrote:
McGilicutty wrote:Further, some companies have huge cash hoards that help support the stock price. Apple's market capitalization is $628 billion, but they have over $200 billion in cash on hand. Apple has about 5.4 billion shares outstanding, so if it ever trades for a buck, you can kind of look at as paying $5.4 billion to get over $200 billion in cash plus a claim on future earnings.


I get that, but that scenario only works if you can wrest control of the company and take the profits for yourself, absent that, those profits are just there and shareholders can't cash out their shares so short of controlling the cash reserves, what's the benefit? In other words, there's a lot of talk of what a share entitles you to and what you own, but if you can't convert that ownership into cash outside of just selling it to someone else who's willing to buy it (say, if no one is buying nor selling), then you don't really have any tangible value.


The problem with a company having so much cash on its balance sheet is that the acquiring company effectively uses the acquired company's cash to make the purchase. If I could write a check for $628 billion and buy every share of Apple that is outstanding, I would actually only be spending $428 billion as that $200 billion in cash would now be mine!

As a practical matter, Apple has such a large market cap that even Warren Buffett couldn't do this without floating an awful lot of new Berkshire-Hathaway stock. Apple is not a takeover candidate.

For a smaller very cash rich company, this can be a big problem as it makes them an easier takeover target. Cash generates very little interest now a days, so having that much cash would be a drag on earnings.
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Re: A few very basic investing theory questions that have bugged me lately

Postby mcraepat9 » Sat Jan 07, 2017 12:17 pm

blaugranamd wrote:3. I understand that concept of losing control of the company if a company has >50% of their outstanding shares publicly owned. But assuming there are not enough outstanding shares owned by someone other than the original company founds to lose control of the company, why would they care?


For a company like that (a "controlled company" in NYSE/NASDAQ parlance), the private owners care a lot about what the shares are worth. At some point, they will look for an exit and want to get paid what the company is worth. Do you think that if Facebook was owned 51% by Mark Z and 49% by the public, that Mark Z wouldn't care about Facebook's share price?

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Re: A few very basic investing theory questions that have bugged me lately

Postby TheTimeLord » Sat Jan 07, 2017 12:20 pm

blaugranamd wrote:
McGilicutty wrote:Further, some companies have huge cash hoards that help support the stock price. Apple's market capitalization is $628 billion, but they have over $200 billion in cash on hand. Apple has about 5.4 billion shares outstanding, so if it ever trades for a buck, you can kind of look at as paying $5.4 billion to get over $200 billion in cash plus a claim on future earnings.


I get that, but that scenario only works if you can wrest control of the company and take the profits for yourself, absent that, those profits are just there and shareholders can't cash out their shares so short of controlling the cash reserves, what's the benefit? In other words, there's a lot of talk here of what a share entitles you to and what you own, but if you can't convert that ownership into cash outside of just selling it to someone else who's willing to buy it (say, if no one is buying nor selling), then you don't really have any tangible value.


Why do you need a way to convert it into cash outside of selling it. If they distributed all the cash to you the value of the stock would drop and be worth less. Shareholders also have voting rights and elect the board. But yes if you own 100 shares of XYZ corp you have no practical influence on the company, you are an extreme minority own who benefits from the value companies create to serve their larger shareholders. What owning shares of stock allows you to do is obtain and liquidate very small partial ownership stakes in large corporations without the agreement of the majority of the shareholders to sell the entire company to some other entity. Although you also profit in that case also. The reality is that anything for sale is only worth what a buyer will pay the seller for it whether it be an ounce of gold, a share of stock or a Bentley.
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Re: A few very basic investing theory questions that have bugged me lately

Postby alex_686 » Sat Jan 07, 2017 12:36 pm

blaugranamd wrote:1. So the answer really is "sort of" active management. Just with virtually minimal activity.


Why is the egg laying platypus, my most favorite creature, considered a mammal? Why is Pluto considered a dwarf planet and not a full planet? I would disagree with your assessment. I have worked in this field and there are lots of burly lines. I have spent many days trying to figure out if a hybrid security issued by a utility was a stock or a bond.

blaugranamd wrote:3. I understand that concept of losing control of the company if a company has >50% of their outstanding shares publicly owned. But assuming there are not enough outstanding shares owned by someone other than the original company founds to lose control of the company, why would they care?


This is a very good question. In most countries minority interests are protected. In the US the board must consider all shareholders, not just the majority shareholder. If Apple was selling at $1, I could start a hostile takeover at $2. The board has to consider the offer even if the founder wants to nix it. The long running battle over Craigslist is a good recent example of this.

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Re: A few very basic investing theory questions that have bugged me lately

Postby blaugranamd » Sat Jan 07, 2017 12:43 pm

TheTimeLord wrote:
blaugranamd wrote:
McGilicutty wrote:Further, some companies have huge cash hoards that help support the stock price. Apple's market capitalization is $628 billion, but they have over $200 billion in cash on hand. Apple has about 5.4 billion shares outstanding, so if it ever trades for a buck, you can kind of look at as paying $5.4 billion to get over $200 billion in cash plus a claim on future earnings.


I get that, but that scenario only works if you can wrest control of the company and take the profits for yourself, absent that, those profits are just there and shareholders can't cash out their shares so short of controlling the cash reserves, what's the benefit? In other words, there's a lot of talk here of what a share entitles you to and what you own, but if you can't convert that ownership into cash outside of just selling it to someone else who's willing to buy it (say, if no one is buying nor selling), then you don't really have any tangible value.


Why do you need a way to convert it into cash outside of selling it. If they distributed all the cash to you the value of the stock would drop and be worth less. Shareholders also have voting rights and elect the board. But yes if you own 100 shares of XYZ corp you have no practical influence on the company, you are an extreme minority own who benefits from the value companies create to serve their larger shareholders. What owning shares of stock allows you to do is obtain and liquidate very small partial ownership stakes in large corporations without the agreement of the majority of the shareholders to sell the entire company to some other entity. Although you also profit in that case also. The reality is that anything for sale is only worth what a buyer will pay the seller for it whether it be an ounce of gold, a share of stock or a Bentley.


That's the point i'm trying to get at: why would anyone pay me for the share if they can't do anything with it other than sell it to someone else for more money? If the stock had some intrinsic value, like the ability to turn it in to the company to claim some portion of their current value/cash, then I would understand someone wanting to buy it off of me thinking in 5 years the company will have more value/cash and their fractional share will be worth a larger "cash out" later and worth buying. If a stock never pays dividends or provides me with some useful benefit, then all a stock allows me to do is say "I own 1/1,000,000,000th of Company A" while I wait for that company to eventually go out of business (which every company will eventually do, given enough time) and I will own nothing.

IF tomorrow no one was buying or selling any stocks, we would all still be fractional owners of companies and if those stocks weren't generating any money for us, they would be of no value. But if a stock has some intrinsic right, like a "cash claim" as noted above, then it still is worth something.
Last edited by blaugranamd on Sat Jan 07, 2017 12:50 pm, edited 2 times in total.
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Re: A few very basic investing theory questions that have bugged me lately

Postby edge » Sat Jan 07, 2017 12:45 pm

Companies care about the value of their stock for many reasons. One that hasn't been mentioned is they they often acquire other companies using stock. If your stock trades at a high multiple it makes it easier to acquire lower multiple businesses in the same industry and 'improve' them by making the acquired company look more like the higher multiple one.

blaugranamd wrote:Ned,

Thanks for the reply!

1. So the answer really is "sort of" active management. Just with virtually minimal activity.

2. I understand the P/E, P/BV, and all of that. But my question is WHY does any of that matter? If a companies profits double, why is the stock worth any more if the stockholders don't get any of that money? If I bought rookie NFL trading cards of Aaron Rodgers and Jason Campbell in 2005 the day they were drafted, the Rodgers card is worth a lot more because he's more famous and did better, but that's only because more people want it. If no one wanted it tomorrow, it would be intrinsically worthless. If I buy stock in Company A and Company B for $1 per share today in 10 years if company B has profits of 100x more than Company A but neither pay dividends, what makes Company B stock more valuable other than people assign it more value because we've all just accepted that, for no real reason other than we think company success should be tied to stock prices?


As far as ownership in the value of the company, I get that, but if I own, say 5% of all outstanding Apple shares, I can't just call up Apple and demand 5% of the current value of the company to cash-out my stock, yes?

3. I understand that concept of losing control of the company if a company has >50% of their outstanding shares publicly owned. But assuming there are not enough outstanding shares owned by someone other than the original company founds to lose control of the company, why would they care?

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Re: A few very basic investing theory questions that have bugged me lately

Postby alex_686 » Sat Jan 07, 2017 1:07 pm

blaugranamd wrote:That's the point i'm trying to get at: why would anyone pay me for the share if they can't do anything with it other than sell it to someone else for more money?


Another good question. The board is supposed to look out for all investors. A company is a little like a democracy, There are different factions that would like to go in different directions but ultimately the company can only go down one road. I think the history of proxy battles is fun.

But what if the board is not running the company for the benefit of all. Maybe they are running to benefit the managers or the founders? Well, then the stock price is negatively effected. Lots of fun history here. Currently, in the USA, if a stock price falls below 20% bad things start to happen. Activist hedge funds move in to kick out the board, buy out funds look to take the company private, Carl Icahn starts talking with the board, etc. Much depends on market structures, for example law and the existence of hedge funds.

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Re: A few very basic investing theory questions that have bugged me lately

Postby lack_ey » Sat Jan 07, 2017 1:12 pm

A lot of a stock's value in general, including for current dividend payers, is predicated on the assumption that one is able to sell in the future, likely at a higher price and probably not at something far below the current. The liquidity is worth something.

i.e. the whole system is based on presumptions of future buyers, so if you distrust the prices of one company based on its not paying dividends, take a closer look at everything

If you required every stock that was bought to be held indefinitely, the market prices would fall significantly.

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Re: A few very basic investing theory questions that have bugged me lately

Postby TheTimeLord » Sat Jan 07, 2017 1:14 pm

blaugranamd wrote:IF tomorrow no one was buying or selling any stocks, we would all still be fractional owners of companies and if those stocks weren't generating any money for us, they would be of no value. But if a stock has some intrinsic right, like a "cash claim" as noted above, then it still is worth something.



So you are saying you are believe a company with positive cash flow, quarterly profits and a host of assets and patents is in danger of tomorrow having no buyers for their stock at any price, no one would want to own that enterprise. The idea behind most growing companies is to increase their value either by investing internally to create organic growth or to leverage their equity in purchasing other companies to aid in that value creation. A share of stock is not a denominated piece of currency with a set value, its value fluctuates day by day, minute by minute based on the perceived value of the enterprise at that moment. Stock represents an ownership claim to a faction of a company if the company is sold or liquidated then you would be distributed your portion of the proceeds otherwise it is purely based on the perceived value given to it by the last trade between a buyer and seller. Just do be clear the owners of the company are the shareholders, and just like with a small business the owners hire people to run the business (for large corporation that is done through board elections) the company does not own itself.
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Re: A few very basic investing theory questions that have bugged me lately

Postby blaugranamd » Sat Jan 07, 2017 1:24 pm

TheTimeLord wrote:
blaugranamd wrote:IF tomorrow no one was buying or selling any stocks, we would all still be fractional owners of companies and if those stocks weren't generating any money for us, they would be of no value. But if a stock has some intrinsic right, like a "cash claim" as noted above, then it still is worth something.



So you are saying you are believe a company with positive cash flow, quarterly profits and a host of assets and patents is in danger of tomorrow having no buyers for their stock at any price, no one would want to own that enterprise. The idea behind most growing companies is to increase their value either by investing internally to create organic growth or to leverage their equity in purchasing other companies to aid in that value creation. A share of stock is not a denominated piece of currency with a set value, its value fluctuates day by day, minute by minute based on the perceived value of the enterprise at that moment. Stock represents an ownership claim to a faction of a company if the company is sold or liquidated then you would be distributed your portion of the proceeds otherwise it is purely based on the perceived value given to it by the last trade between a buyer and seller. Just do be clear the owners of the company are the shareholders, and just like with a small business the owners hire people to run the business (for large corporation that is done through board elections) the company does not own itself.


I don't believe that scenario will ever happen, hence this is just theoretical and a mental exercise. I'm trying to get to the answer of a very basic but apparently complex question: absent the notion of selling a stock to someone else (secondary value), what is a stock's intrinsic value? Why should it be worth anything to me of it's own right? In the setting of dividends, I get it: the company makes a profit, company distributes some of that profit to the "owners" essentially paying them all a "salary" as partial owners. I doubt anyone buys a share of Berkshire Hathaway thinking one day all the company's assets will be liquidated and they will be paid more per share then when they bought it.
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Re: A few very basic investing theory questions that have bugged me lately

Postby taguscove » Sat Jan 07, 2017 2:03 pm

blaugranamd wrote:
TheTimeLord wrote:
blaugranamd wrote:
McGilicutty wrote:Further, some companies have huge cash hoards that help support the stock price. Apple's market capitalization is $628 billion, but they have over $200 billion in cash on hand. Apple has about 5.4 billion shares outstanding, so if it ever trades for a buck, you can kind of look at as paying $5.4 billion to get over $200 billion in cash plus a claim on future earnings.


I get that, but that scenario only works if you can wrest control of the company and take the profits for yourself, absent that, those profits are just there and shareholders can't cash out their shares so short of controlling the cash reserves, what's the benefit? In other words, there's a lot of talk here of what a share entitles you to and what you own, but if you can't convert that ownership into cash outside of just selling it to someone else who's willing to buy it (say, if no one is buying nor selling), then you don't really have any tangible value.


Why do you need a way to convert it into cash outside of selling it. If they distributed all the cash to you the value of the stock would drop and be worth less. Shareholders also have voting rights and elect the board. But yes if you own 100 shares of XYZ corp you have no practical influence on the company, you are an extreme minority own who benefits from the value companies create to serve their larger shareholders. What owning shares of stock allows you to do is obtain and liquidate very small partial ownership stakes in large corporations without the agreement of the majority of the shareholders to sell the entire company to some other entity. Although you also profit in that case also. The reality is that anything for sale is only worth what a buyer will pay the seller for it whether it be an ounce of gold, a share of stock or a Bentley.


That's the point i'm trying to get at: why would anyone pay me for the share if they can't do anything with it other than sell it to someone else for more money? If the stock had some intrinsic value, like the ability to turn it in to the company to claim some portion of their current value/cash, then I would understand someone wanting to buy it off of me thinking in 5 years the company will have more value/cash and their fractional share will be worth a larger "cash out" later and worth buying. If a stock never pays dividends or provides me with some useful benefit, then all a stock allows me to do is say "I own 1/1,000,000,000th of Company A" while I wait for that company to eventually go out of business (which every company will eventually do, given enough time) and I will own nothing.

IF tomorrow no one was buying or selling any stocks, we would all still be fractional owners of companies and if those stocks weren't generating any money for us, they would be of no value. But if a stock has some intrinsic right, like a "cash claim" as noted above, then it still is worth something.


Publicly traded companies are complicated, it's understandable it can get confusing. In my experience talking real estate is a simpler concept.

Imagine there's a home with one owner. What gives the home (or any asset) intrinsic value? Something has value if other humans want that asset. Homes provide useful things like shelter. Even if you own the house, but can't live in it, there's plenty of people willing to rent the house.
By an extension, companies like Apple, McDonald's, etc. provide products that humans want.
Real estate -> shelter -> rent
Companies -> product/service -> dividend

Publicly traded companies just split up ownership. Imagine that home, except now there's 10 shares of ownership. A complete stranger is willing to buy a share because the underlying asset has value. Similarly, someone will buy a share because the underlying company has value.

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Re: A few very basic investing theory questions that have bugged me lately

Postby pkcrafter » Sat Jan 07, 2017 2:19 pm

1. If indices like the S&P 500 are selected by a committee based on requirements of fundamental analysis, then by extension aren't index funds that track the S&P 500 really just indirectly actively managed funds since the underlying index is actively managed?

The big difference between an index and an actively managed fund is the index committee is only concerned with tracking it's target index. There is no attempt to beat the index. Active managments goal is to select stocks that will beat the index.

2. What is it about a stock that gives it an intrinsic value? I understand the benefit if a stock is dividend paying, say like Johnson and Johnson or P&G. But why does a stock like Berkshire Hathaway have value? A few things: I get that it's fractional ownership in a company but why is owning part of that company valuable? Does a share of stock entitle someone to a fraction of the companies current total value? Sometimes it seems like stocks are nothing more than baseball cards with a particular company's name on them.

Intrinsic value is an estimate of the actual value of a company as opposed to its market value. I am distrustful of intrinsic value determinations because it contains subjective estimates on things like brand name, trademarks, and copyrights. Also, there are different techniques to measure it. Different people with place different values on things like brand name, etc.


3. Why does any company care what the value of their outstanding shares are? By this I mean in an IPO the company brings in capital in exchange for selling some of it's company ownership to the public. But after that, the stock market is a secondary market that seems to correlate with company value/performance simply because we think it should.

There is no difference between value as IPO and later on. The stock market is not a secondary market. Each stock (owership of a company) is based on what the markets (we) believe is a fair value. That holds sometimes and sometimes not. Distortions occur because of investors perceptions of future value, euphoria and fear.

If tomorrow everyone in the world woke up and decided they wouldn't pay more than $1 for Apple stock, then the value of Apple stock would be $1.

While that is true in theory, it ain't gonna happen. Other than that, other posters have provided accurate answers.
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Re: A few very basic investing theory questions that have bugged me lately

Postby ogd » Sat Jan 07, 2017 2:38 pm

blaugranamd wrote:2. What is it about a stock that gives it an intrinsic value? I understand the benefit if a stock is dividend paying, say like Johnson and Johnson or P&G. But why does a stock like Berkshire Hathaway have value? A few things: I get that it's fractional ownership in a company but why is owning part of that company valuable? Does a share of stock entitle someone to a fraction of the companies current total value? Sometimes it seems like stocks are nothing more than baseball cards with a particular company's name on them.

So you have a company like Google, that isn't paying dividends and possibly never will, but makes tens of billions profit every year, and you're comparing it to baseball cards that just sit there being pretty? Don't you think there's something wrong with this thesis even if you had no idea at all what others are willing to pay for Google shares? I could be completely isolated from market prices and still think that it has to be worth something between tens and hundreds of billions. Has to.

The company makes tens of billions of dollars in your name, an ownership stake protected by shareholder rights -- the same, btw, that protect the other 97% of your investment in a dividend-paying company that paid 3% this year. If you didn't trust company management or shareholder rights, you wouldn't invest at all, or certainly not at valuations that account for the other 97% not being turned into dust.

Most commonly, you will get your money and profits back by selling shares to others who want a piece of that action (because -- again -- they can see the tens of billions and not have to trust a fickle collectible market value). But there are many other ways for you to get back your money, see below.

nisiprius wrote:I am inclined to agree with those (notably including Jeremy Siegel, author of "stocks for the long run" that the intrinsic value is the present value (discounted) of the future stream of dividends. Period. End of story.

I on the other hand think that this method of "intrinsic valuation" is pretty much worthless. At best a saying like "Early to bed and early to rise, makes a man healthy, wealthy and wise.” Some truth to that, but not a diagnostic method.

There are many other ways for a company that doesn't pay dividends to return all that accumulated value:
0) Future, unknown dividends (this is more for blaugranamd above)
1) Share buybacks. This is a direct method of giving company cash to shareholders and is the preferred one in the current tax regimen. I believe
2) Company gets acquired
3) Spinoff of subdivisons
4) Dissolution
5) Suing management to force them to return cash. Even if you are somehow absolutely sure company won't do any of 0-4, there is still the possibility of a lawsuit forcing them to.

It's already next to impossible to guess at the future dividends and their timelines -- could you seriously have valued Apple in 2007, with iPhone in the picture, based only on its dividends from 2012 onwards? Then you add these other options -- you could go ahead and try to figure out the probability of a sale of size Y, but it would be a monumentally difficult task.

Instead, eveyone pretty much takes the shortcut: however the company pays, it will have to be based on earnings between now and then. So future earnings are all that matter.

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Re: A few very basic investing theory questions that have bugged me lately

Postby blaugranamd » Sat Jan 07, 2017 2:52 pm

ogd wrote:
blaugranamd wrote:2. What is it about a stock that gives it an intrinsic value? I understand the benefit if a stock is dividend paying, say like Johnson and Johnson or P&G. But why does a stock like Berkshire Hathaway have value? A few things: I get that it's fractional ownership in a company but why is owning part of that company valuable? Does a share of stock entitle someone to a fraction of the companies current total value? Sometimes it seems like stocks are nothing more than baseball cards with a particular company's name on them.

So you have a company like Google, that isn't paying dividends and possibly never will, but makes tens of billions profit every year, and you're comparing it to baseball cards that just sit there being pretty? Don't you think there's something wrong with this thesis even if you had no idea at all what others are willing to pay for Google shares? I could be completely isolated from market prices and still think that it has to be worth something between tens and hundreds of billions. Has to.

The company makes tens of billions of dollars in your name, an ownership stake protected by shareholder rights -- the same, btw, that protect the other 97% of your investment in a dividend-paying company that paid 3% this year. If you didn't trust company management or shareholder rights, you wouldn't invest at all, or certainly not at valuations that account for the other 97% not being turned into dust.

Most commonly, you will get your money and profits back by selling shares to others who want a piece of that action (because -- again -- they can see the tens of billions and not have to trust a fickle collectible market value). But there are many other ways for you to get back your money, see below.


You're missing my point. If Google has billions of dollars but my share doesn't actually entitle me to any of that, then what does it matter? Saying Google share is worth more than another company because they have lots of cash even though I can't have any of it is not different than saying Aaron Rodgers trading card is worth more than Jason Campbell because Aaron Rodgers makes more money. See what I mean?

Yes, there are ways wherein you could get some money back like buy backs, eventually dividend payments. Etc, those are tangibles values I get.

Maybe I'm hunting for a more esoteric answer that doesn't exist, like the meaning of life here. I appreciate the discussion though :confused
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Re: A few very basic investing theory questions that have bugged me lately

Postby alex_686 » Sat Jan 07, 2017 3:10 pm

blaugranamd wrote:You're missing my point. If Google has billions of dollars but my share doesn't actually entitle me to any of that, then what does it matter? Saying Google share is worth more than another company because they have lots of cash even though I can't have any of it is not different than saying Aaron Rodgers trading card is worth more than Jason Campbell because Aaron Rodgers makes more money. See what I mean?

Yes, there are ways wherein you could get some money back like buy backs, eventually dividend payments. Etc, those are tangibles values I get.

Maybe I'm hunting for a more esoteric answer that doesn't exist, like the meaning of life here. I appreciate the discussion though :confused


You share does entitle you to a fraction of that. Now maybe you feel like you are not getting that money back fast enough via dividends, stock buy backs, etc. O.k. Now go back to my post about proxy battles and Carl Icahn. Look specifically at Apple. They had billions of dollars of profits in cash just sitting on the books, doing nothing. Lots of shareholders wanted Apple to return the cash. Carl Icahn was highly visible in this effort but there were others. Apple's board eventually agreed.

If Apple's board had resisted then maybe Mr. Icahn would have lead a buy out of the firm and would have returned cash to the shareholders that way. Or maybe he would have lad a proxy battle to force the board to distribute the profits.

In any case, in America, if things get to far out of what the intrinsic market value is there are ways that the market corrects.

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Re: A few very basic investing theory questions that have bugged me lately

Postby ogd » Sat Jan 07, 2017 3:28 pm

blaugranamd wrote:You're missing my point. If Google has billions of dollars but my share doesn't actually entitle me to any of that, then what does it matter? Saying Google share is worth more than another company because they have lots of cash even though I can't have any of it is not different than saying Aaron Rodgers trading card is worth more than Jason Campbell because Aaron Rodgers makes more money. See what I mean?

I'm not missing your point at all. Your share 1) does entitle you to all of that (and management is required to manage it with your interests in mind), but 2) you don't get to choose the form and timeline of cash returns. Those are the rules. #1 is extremely important and it's needed for the existence of a stock market, whereas #2 turns out to matter not at all, despite the weight you seem to put on it -- if you don't like how the company returns accumulated cash you can always sell a portion of it to people who prefer a different shape and timeline or cash returns (such as people who have to pay taxes). The important thing is the company makes money.

The trading card analogy doesn't apply at all -- like I was saying, with no information from the stock market at all I can look at Google's earnings and prospects and make a pretty good guess about what shares could be worth -- very likely within 2x of the actual value, and even more likely with good relative valuations to other stocks. Whereas if I tried to do this with cards, I'd be completely and extremely wrong. If I know nothing about the trading card market -- and forget the "if", I actually don't -- there's no value I can put on trading cards. I'd be most inclined to value Aaron Rodgers as a $1 greeting card to my Wisconsin friends, and Jason Campbell -- no idea, would have to Google him. Or to put it another way, Aaron Rodgers's earnings are not held in my bame, so they don't mreally matter for the value of my cars.

The reason this is reassuring to you is that as long as Google actually does well, you don't need to depend on fickle market opinions to be assured your investment doesn't crash 100x like trading cards. If Google does badly, having paid a dividend won't save you any more than selling a little bit of the company would -- or not at all if you proudly reinvest dividends.

Yes, there are ways wherein you could get some money back like buy backs, eventually dividend payments. Etc, those are tangibles values I get.

It's more than an "etc" -- those ways I listed are a virtual certainty for all companies that do well. Companies that do badly will eventually be worth zero, and if you want to hedge against that you can always sell a little bit of your share, the same way that you don't reinvest dividends.

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Re: A few very basic investing theory questions that have bugged me lately

Postby rongos » Sat Jan 07, 2017 3:41 pm

Why is an S&P500 index fund like Vanguard considered un-managed?
Because Vanguard (and other copy-cat index fund providers) is not picking the stocks, someone else is.

What is a stock worth?
Whatever someone is willing to pay for it.

What should a stock be worth, its "intrinsic" value?
A couple purely monetary reasons someone would buy the stock, allowing you to arrive at a real "intrinsic" price:
1. Dividends (price = future dividends, adjusted for risk)

2. To accumulate ownership of more than 50% of company to control the company or possibly buy it out (price = book value or future value of company divided by number of shares).

3. (fun answer) In cases like Berkshire Hathaway, you get to attend cool shareholder events

Because of the huge difference between the answers to the two questions above, I would agree with anyone saying that stocks are built on a very precarious premise, that the investing public can someday wake up on a massive scale and decide that stocks are not worth what people are paying for it today.

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Re: A few very basic investing theory questions that have bugged me lately

Postby ReadyOrNot » Sat Jan 07, 2017 8:17 pm

1. Sometimes people looking for arguments against index funds do argue that there is some selection of what goes into the index. True, but there is a gradual scale. If the selection criteria are primarily to try to represent the total market, its pretty close to the passive end of the scale. Exactly scaling the total market would be considered passive, but impractical. So a total market index is about as close as you will find for passive, and people may just call it passive.

2. The idea of a market setting the value seems to bother you. But market value is what it is, even if it is changeable.
Would it bother you to pay $200K for a house that the previous owner paid $40K for 15 or 20 years ago? Would it bother you to pay $300K for a house a speculator bought for $200K 2 years ago. Or to pay taxes on a recent tax assessment of $250K when the pre-selling tax assessment valued it at $60K? (Prices crashed in the last recession.) What is the intrinsic value of that property, anyway? The tax assessor is apparently going to use something close to the market value. Is that fair? Most of that is driven by the speculators who have been driving up prices in the area.
Many years ago, Campbell soup was selling for 40 or 50 cents a can. The makers did some market research and found that people valued canned soup higher and would be willing to pay more. So a few years later the cost was around $0.90 to $1. No particular reason, except that the makers found that they could get more.
Eggs were around $1 a dozen. But some areas of the country had temporary shortages, and some local prices shot up as high as $3 a dozen. Many places found consumers willing to pay it. Some places kept the $3 prices even when the shortages went away. Why do eggs cost $1 or $3 depending on location? Just because its the market price.
A few years ago, some investors noticed that some companies' stock valuations were lower than the "book" value of their assets. They found it easy to convince banks to loan them enough money to buy controlling interest in companies and sell off enough of their assets to pay back the loans, and sell off the other pieces to make big profits. They called them "leveraged buy-outs". So yes, sometimes the "book" value of a company can be as much as or exceed the market value of the company. (Sort of, I guess, if the sold-off pieces were the new market value--you can come up with your own interpretation.)
Anyway, like it or not, market value is a real value that people pay.
People apparently will pay some price to own a piece of a company--they must value owning a piece of the company. Sure, why not. Wouldn't you pay $1000 for a 10% share of a profitable, well-managed $10,000 business? Well, maybe not, but some investors do, and you can see why it might seem reasonable.

3. Would raising the value of the company make the owners happy?
Would one of the business goals of the owners be to have the value of their shares of the company go up?
Would the owners direct the managers of the company to work on increasing the value of the company?
Would the managers try to do what the owners directed them to do?

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Re: A few very basic investing theory questions that have bugged me lately

Postby Wakefield1 » Sat Jan 07, 2017 8:43 pm

nisiprius wrote:
blaugranamd wrote:As I've pursued my "continuing financial education" over the last few weeks, a few questions have begun to perplex me and I'm hoping the Bogleheads may be able to shed some light on these for me:



I am inclined to agree with those (notably including Jeremy Siegel, author of "stocks for the long run" that the intrinsic value is the present value (discounted) of the future stream of dividends. Period. End of story.
^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^
In the case of stocks that don't pay dividends, nobody likes to talk about it but everybody understand that that is a situation that can't continue forever. Shareholders will tolerate it while the company is in a growth phase, but when it matures they demand dividends. Thus, both Apple and Microsoft--while still highly successful--paid dividends once they "grew up."


I accept that view of intrinsic value. Does Mr. Bogle quote that (about the importance of dividends?)
Tax laws that punished dividends(as opposed to retained earnings or buybacks probably distorted things but the present "qualified dividends" treatment in my opinion puts things more as they should be

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Re: A few very basic investing theory questions that have bugged me lately

Postby bamn » Sat Jan 07, 2017 9:35 pm

blaugranamd,

I hear you loud and clear on #2 ! This bothers me too. I jumped in on a thread about the 'purpose' of dividends a while back, where someone griped about dividends, and how we'd be better to avoid them entirely (from a taxation perspective). I argued that stocks would have no value whatsoever if 'company earnings get paid to owners' wasn't a core concept; so you couldn't rely on capital appreciation, since there wouldn't be any.

I imagine starting a restaurant. Then, I say to a few buddies, give me $10,000 each to 'buy in'. You'll own part of the business. However, you won't get to share in the profits that are made serving meals to patrons... ever. They'd never take me up on it. Ownership would be meaningless and completely detached from the actual act of 'doing business'. And anyone who did would never be able to re-sell his share. Sure, you can expect profits to be re-invested while the company is growing, but the entire purpose of a business is to eventually earn money for its owners.

I think that ultimately that the future outlook on dividends is really what valuations must be anchored in. Certainly, layered on top of is speculation on what you might sell a piece of that action for. So long as it's believable that dividends can someday be paid out, people will continue to trade the stock on the assumption that its value is increasing (and in turn ensuring that very thing; a self-fulling prophecy).

That's my theory. This does bother me too.

#1. The S&P 500 may be actively run in terms of "choosing" who's in or out (but I think it generally only affects businesses near the 'bottom'), but the index is still market-cap weighted. So, in a fund based on such an index, the proportion of each company that you hold is still very much passive in that it relies on market pricing, not the committee. The committee only influences the scope of the thing.

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Re: A few very basic investing theory questions that have bugged me lately

Postby Valuethinker » Sun Jan 08, 2017 7:48 am

blaugranamd wrote:As I've pursued my "continuing financial education" over the last few weeks, a few questions have begun to perplex me and I'm hoping the Bogleheads may be able to shed some light on these for me:

1. If indices like the S&P 500 are selected by a committee based on requirements of fundamental analysis, then by extension aren't index funds that track the S&P 500 really just indirectly actively managed funds since the underlying index is actively managed?


An example of a correct but not helpful argument. In the sense that the S&P500 is selected fairly mechanically (but not perfectly so) it is "as good as" a machine generated index (like some of the Russell ones) for practical purposes.

2. What is it about a stock that gives it an intrinsic value? I understand the benefit if a stock is dividend paying, say like Johnson and Johnson or P&G. But why does a stock like Berkshire Hathaway have value? A few things: I get that it's fractional ownership in a company but why is owning part of that company valuable? Does a share of stock entitle someone to a fraction of the companies current total value? Sometimes it seems like stocks are nothing more than baseball cards with a particular company's name on them.


At some point in the future:

- those assets will be realized and the cash distributed as dividends or share buybacks (BH buys back shares quite often)-- for shareholder purposes buybacks & dividends have the same effects (assuming no tax)
- if management doesn't do that eventually the company will get taken over and the selling shareholders (ie you) will get out the value of the company

3. Why does any company care what the value of their outstanding shares are? By this I mean in an IPO the company brings in capital in exchange for selling some of it's company ownership to the public. But after that, the stock market is a secondary market that seems to correlate with company value/performance simply because we think it should. If tomorrow everyone in the world woke up and decided they wouldn't pay more than $1 for Apple stock, then the value of Apple stock would be $1 and billions of dollars would be lost. But that shouldn't affect Apple, they still have the same amount of physical and intellectual property assets, they are still bringing in profits, they haven't really lost anything other than being able to claim whatever fraction of ownership they retained as assets. So why does a company care what the current secondary market value of their shares are?

:sharebeer for any help understanding these things!


1. if the company needs to raise more equity or debt, then the market value of its shares is relevant. A higher stock issue price means less dilution for existing shareholders for the same amount of money ie a lower cost of equity capital. (the connection to the debt is a little more complex)

2. executives and employees are often remunerated with Restricted Stock Units or options and thus have compensation and motivation linked to the share price

3. if the Founders want to sell shares in the future, they want a high share price

4. If a company has a share price close to zero, then customers, suppliers and employees may take it as a sign of financial distress and that will impede the company's ability to business day-to-day

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Re: A few very basic investing theory questions that have bugged me lately

Postby nedsaid » Wed Jan 11, 2017 12:26 am

blaugranamd wrote:Ned,

Thanks for the reply!

1. So the answer really is "sort of" active management. Just with virtually minimal activity.

Nedsaid: The index funds also screen out what I call the "anti-factors", that is stocks with characteristics that are so bad that they are guaranteed to be a drag on performance. The very most speculative stocks just will not be in an index.

2. I understand the P/E, P/BV, and all of that. But my question is WHY does any of that matter?

Nedsaid: It matters because valuations matter. It matters because stock investors favor certain characteristics in stocks over other characteristics. When you buy a stock or a bond, you are buying a set of cash flows. And remember that stocks trade at a multiple of their earnings. If you don't understand this, you won't understand anything else I say.

Stocks tend to go up over time because the underlying companies tend to grow their earnings over time, companies tend to grow their earnings over time because the economy tends to grow over time.

What characteristics of stocks do investors favor? Investors will pay more for a stream of earnings if that stream of earnings grows over time. Investors will pay even more if those earnings grow consistently. You can get an even higher price if the earnings grow fast.

It is a perception of value and a perception of quality. Why do people pay more for a Lexus than a Camry? It is perceived value.


If a companies profits double, why is the stock worth any more if the stockholders don't get any of that money?

Nedsaid: This is why you have a stock market. Participants can trade with each other based on perceptions of quality and value. The stockholders get more cash if the company increases its dividend. But if you want to convert the increased value of the company resulting from doubled earnings into cash, you will have to sell the stock.

If the earnings stream of a company's earnings double, you would expect the price of the stock to go up.



If I bought rookie NFL trading cards of Aaron Rodgers and Jason Campbell in 2005 the day they were drafted, the Rodgers card is worth a lot more because he's more famous and did better, but that's only because more people want it. If no one wanted it tomorrow, it would be intrinsically worthless.

Nedsaid: You are missing my point. NFL Trading Cards have value but it is speculative value based on the popularity of the players and how much someone wants to pay for the card. The Trading Cards generate no cash flow. It is just supply and demand. A Trading Card has no economic value in itself, it is a subjective judgment by the participants of the Trading Card market.

Stocks and bonds generate cash flows. So there is a fundamental that you can use to determine intrinsic value. With bonds, you get actual cash payments and your money back when the bond matures. With stocks, you get actual cash payments if the stock pays a dividend. The stock market looks ahead and forecasts future cash flows and assigns a value to those forecasted cash flows. There is an actual company behind the stock and there is actual economic value in the stock from the assets the company holds and the value of its cash flows.

As Jack Bogle would say, with stocks you have not only business or economic return but you have speculative return. Just like trading cards, the market can "bid up" a stock to irrational levels in the short term. In the long run, the business return or economic return of a stock and its investment return will be identical. Over the long run, the return on American Business is about 10 percent; thus we shouldn't be shocked that the returns of the stock market are almost exactly the same. That is because when you buy a stock, you buy a share of someone's business.


If I buy stock in Company A and Company B for $1 per share today in 10 years if company B has profits of 100x more than Company A but neither pay dividends, what makes Company B stock more valuable other than people assign it more value because we've all just accepted that, for no real reason other than we think company success should be tied to stock prices?

Nedsaid: Company B would worth more because it not only has more profits than Company A but also grew those profits faster. It is all about cash flows and making estimates about the future. Again, stocks are fractional ownership of real companies making real products and services. These real companies make real profits. This is real life and not playing Monopoly.

As far as ownership in the value of the company, I get that, but if I own, say 5% of all outstanding Apple shares, I can't just call up Apple and demand 5% of the current value of the company to cash-out my stock, yes?

Nedsaid: The Apple Board could pass a resolution to buy your 5% stake and retire the shares putting them into Treasury Stock. This would be very unlikely. For one thing, Company Boards only meet a few times a year. Secondly, companies buy their own stock to decrease the amount of shares outstanding, thus increasing earnings per share. Very rarely they would do this to buy out a dissident shareholder, and even then this would be done in the case of very small companies. You would simply call your broker and tell him or her to sell. This is what markets are for.

3. I understand that concept of losing control of the company if a company has >50% of their outstanding shares publicly owned. But assuming there are not enough outstanding shares owned by someone other than the original company founds to lose control of the company, why would they care?

Nedsaid: If you own 5% or 10% of the outstanding shares of a company, you might have enough leverage to demand your own Board seat. Effective control of a company could be done with maybe 20% or 30% of the shares. That is why they would care. For a large publicly traded company, it would take an immense amount of money to do this.
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Re: A few very basic investing theory questions that have bugged me lately

Postby whodidntante » Wed Jan 11, 2017 12:38 am

3. A company's stock is sometimes referred to as its currency. It can raise capital through net issuance, and it can negotiate deals in exchange for its stock, and can compensate employees with stock to some extent. Also, a high market cap means that activist investors and potential suitors really need to put their money where their mouth is. Also, companies are sometimes brought public for tax reasons as much as to raise capital, and you can bet the heirs to the estate of the dying mogul care what happens to the share price.

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Re: A few very basic investing theory questions that have bugged me lately

Postby Ari » Wed Jan 11, 2017 1:31 am

nedsaid wrote:Stocks and bonds generate cash flows.

Stocks that don't pay dividends don't generate cash flows, though.
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Re: A few very basic investing theory questions that have bugged me lately

Postby Valuethinker » Wed Jan 11, 2017 3:52 am

Ari wrote:
nedsaid wrote:Stocks and bonds generate cash flows.

Stocks that don't pay dividends don't generate cash flows, though.


This is the essence of Modigliani & Miller's theorems.

Assuming no tax, then the shareholder is indifferent between the company holding her money in its bank account, or paying it out to her. She still has the same amount of money.

2 exceptions:

- tax makes this more complex. For example the shareholder (Warren Buffett) would pay tax if the company paid WB a dividend on his shareholding

-agency costs exist - managers (agents) are separate from principals (owners) and have different amounts of information about the condition and prospect of the business, and may have differing incentives and motivations. That's not an issue with Berkshire Hathaway, the managers are the largest shareholders. But in most companies it is-- managers own very few shares (stock options don't quite solve this problem) and may be tempted to squander money (which belongs to shareholders) acquiring other companies or making foolish investments

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Re: A few very basic investing theory questions that have bugged me lately

Postby Ari » Wed Jan 11, 2017 4:44 am

Valuethinker wrote:Assuming no tax, then the shareholder is indifferent between the company holding her money in its bank account, or paying it out to her. She still has the same amount of money.

Sure. But if there is no payout, there is no cashflow, which was Nedsaid's argument for why stocks are different from baseball cards.
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Re: A few very basic investing theory questions that have bugged me lately

Postby Dandy » Wed Jan 11, 2017 7:37 am

I will address the index fund being somewhat like an active fund. I think it also goes to intent. An active manager not only is much more active but is trying to pick winners and sell losers, he/she is trying to outsmart the market. People adjusting the make up of an index are trying to pick stocks that represent their index. The growth of Facebook, Google and Amazon etc. means the tech sector is a larger part of the US economy that it was 20 years ago. So an index that is trying to represent the US economy would probably have had add them and remove Kodak, Xerox and Sears to remain representative. (not saying any of these were in or are out of the S&P)

So the people in charge of the index, in a sense end up picking winners in that they are survivors and exiting losers i.e. those companies that have shrunk, gone out of business or merged. I don't think it would make sense to have the S&P 500 index handled any other way.

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Re: A few very basic investing theory questions that have bugged me lately

Postby Quark » Wed Jan 11, 2017 8:30 am

blaugranamd wrote:2. What is it about a stock that gives it an intrinsic value? I understand the benefit if a stock is dividend paying, say like Johnson and Johnson or P&G. But why does a stock like Berkshire Hathaway have value? A few things: I get that it's fractional ownership in a company but why is owning part of that company valuable? Does a share of stock entitle someone to a fraction of the companies current total value? Sometimes it seems like stocks are nothing more than baseball cards with a particular company's name on them.

You have the right to receive a proportional share of dividends, when and if paid.

You have the right to receive a proportional share of the sales price, when and if the company is sold.

You have the right to vote.

You can sue if directors violate their fiduciary duties.

You don't have the right to compel the company to pay dividends or to make any business decisions, including regarding a sale of the company, and you don't have any direct right to access the company's assets.

Control has value, which is one reason buyers pay a premium to buy a company. For example, if you control a company, you can decide to pay dividends or to sell assets and distribute the proceeds.

There may be variations in some of these depending on relevant law or particular circumstances.

It's possible that a company will be formed, never pay dividends and collapse without residual value. That's a risk of stock ownership.

Baseball cards don't represent any rights to an underlying business.

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Re: A few very basic investing theory questions that have bugged me lately

Postby tchoupitoulas » Wed Jan 11, 2017 9:31 am

I'm going to take a crack at explaining #2 since it seems to be causing trouble.

The reason owning stock is different from owning a baseball card is that you literally own a piece of the company. Imagine if by buying all the existing Aaron Rodgers baseball cards you could literally own Aaron Rodgers. That's what it's like. I think it's easiest to understand intuitively if you imagine yourself owning 100% of the shares of a company. Take Apple for instance. If you own the company you own all its physical assets (buildings, equipment, etc.) all its intangible assets (IP, talent, etc.) all of its giant pile of cash, and the right to do what you want with future profits. You also have the right to control the company. Ultimately it is the owners of the company, not management, who get to decide what the company does. That means if you own all the outstanding shares you can fire the managers, take over the board, pay all the profits to yourself in the form of dividends, whatever. Now if you own 5% or even just a few shares it's just a smaller version of the same story. The reason a stock has inherent value is because it represents ownership of a company, which has value because it owns valuable assets and uses those assets to generate profits.

Another helpful thought may be to imagine bankruptcy. Ultimately if you own part of the company that means you are entitled to a portion of its liquidation value if it ever goes out of business. Of course, the bondholders have priority (which is why stocks are generally riskier than bonds) but the bottom line is the same. This is why old school value investors would get excited when they saw a stock they could buy for less than its book value. They felt they were literally paying 80 cents to get a dollar, because by owning the stock they were owning the company and the company itself had assets on its books that were worth more than all the outstanding stock.

Hope this helps.

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Re: A few very basic investing theory questions that have bugged me lately

Postby nedsaid » Wed Jan 11, 2017 11:30 am

Ari wrote:
nedsaid wrote:Stocks and bonds generate cash flows.

Stocks that don't pay dividends don't generate cash flows, though.


Stocks that don't pay dividends still have earnings and earnings are what you are paying for when you buy a stock.
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Re: A few very basic investing theory questions that have bugged me lately

Postby rbaldini » Wed Jan 11, 2017 12:03 pm

I'm glad you are bringing this up.

For me, it's even worse: I don't even really understand the value of dividends. When I get a dividend, the price of my stock falls by just the same amount. So... nothing has happened. This means that, as far as I can tell, pretty much the only reason I buy stock is because I will be able to sell it later for a higher price - whether it pays a dividend or not. If prices don't go up between dividends, I make no money at all. Surely I'm missing something, but I don't know what it is.

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Re: A few very basic investing theory questions that have bugged me lately

Postby nedsaid » Wed Jan 11, 2017 3:58 pm

rbaldini wrote:I'm glad you are bringing this up.

For me, it's even worse: I don't even really understand the value of dividends. When I get a dividend, the price of my stock falls by just the same amount. So... nothing has happened. This means that, as far as I can tell, pretty much the only reason I buy stock is because I will be able to sell it later for a higher price - whether it pays a dividend or not. If prices don't go up between dividends, I make no money at all. Surely I'm missing something, but I don't know what it is.


There are numerous threads out there about dividends. I still have bruises left over from the various discussions.

The academic research indicates that dividends are not in themselves a factor in returns. Two strategies that dividend investors use do tend to outperform the market, high dividend because of the Value factor and dividend growth because of profitability and quality factors. Dividend stocks often do quite well, not because of the dividends themselves, but because of the underlying factors.

For the record, I like dividends and prefer dividend paying stocks over stocks that don't pay a dividend. But I have owned both, stocks that pay dividends and those that don't.

Again, what powers stock prices are earnings. It isn't a greater fool theory.
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Re: A few very basic investing theory questions that have bugged me lately

Postby dgreen » Wed Jan 11, 2017 4:29 pm

This question has really bothered me but the answer is usually circular logic. This is how I see the problem:

Company 1
- Sells shares
- People who buy large amounts of shares can now make company decisions and get shares of the profits (dividends)
- Some people only buy one share. That share entitles them to one unit of the company's profit (a dividend)

Company 2
- Sees success of IPO from company 1 and sells shares
- People who buy large shares can now make company decisions but get no shares of the profits
- Many people who buy too few shares to be able to make any decisions. And although the company is making lots of money, they also don't get any share of the profits.
- Feeling duped, they try to sell their shares to others claiming the company is very valuable. The prospective buyer says, that's great, but do I get a share of this value in any way? Money, products, decision making abilities? Seller of share says no. It's literally just a piece of paper saying you own part of this company.

Why would anyone buy this?

The answer HAS to be, that there is a hope of profit sharing one day or that another company will want to buy out your share. In the Scenario of company 2, there is literally no other value to the share.

I recognize that it is all conceptual at this point though since we've propped it all up with never ending speculation.

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Re: A few very basic investing theory questions that have bugged me lately

Postby nedsaid » Wed Jan 11, 2017 5:33 pm

tchoupitoulas wrote:I'm going to take a crack at explaining #2 since it seems to be causing trouble.

The reason owning stock is different from owning a baseball card is that you literally own a piece of the company. Imagine if by buying all the existing Aaron Rodgers baseball cards you could literally own Aaron Rodgers. That's what it's like. I think it's easiest to understand intuitively if you imagine yourself owning 100% of the shares of a company. Take Apple for instance. If you own the company you own all its physical assets (buildings, equipment, etc.) all its intangible assets (IP, talent, etc.) all of its giant pile of cash, and the right to do what you want with future profits. You also have the right to control the company. Ultimately it is the owners of the company, not management, who get to decide what the company does. That means if you own all the outstanding shares you can fire the managers, take over the board, pay all the profits to yourself in the form of dividends, whatever. Now if you own 5% or even just a few shares it's just a smaller version of the same story. The reason a stock has inherent value is because it represents ownership of a company, which has value because it owns valuable assets and uses those assets to generate profits.

Another helpful thought may be to imagine bankruptcy. Ultimately if you own part of the company that means you are entitled to a portion of its liquidation value if it ever goes out of business. Of course, the bondholders have priority (which is why stocks are generally riskier than bonds) but the bottom line is the same. This is why old school value investors would get excited when they saw a stock they could buy for less than its book value. They felt they were literally paying 80 cents to get a dollar, because by owning the stock they were owning the company and the company itself had assets on its books that were worth more than all the outstanding stock.

Hope this helps.


This is an excellent first post on the forum. I hope you will post more.

I do want to point out that most companies trade for more than their book value. In the example above, Microsoft has a market value of $63 a share or so and a book value of about $9. You are paying for the future earnings power of Microsoft and not just for what the accountants say Microsoft is worth.
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Re: A few very basic investing theory questions that have bugged me lately

Postby Ari » Thu Jan 12, 2017 4:29 am

nedsaid wrote:Stocks that don't pay dividends still have earnings and earnings are what you are paying for when you buy a stock.

Baseball players have earnings, too.

I'm not trying to be snarky. I think there's some truth to the comparison between non-dividend paying stocks and baseball cards. The main difference is that stocks are much more popular, everyone agrees on their value, there are clear, traditional ways of valuing them that most everyone agrees on, etc. But unless there's cash flow going to the stock holder, I don't see a fundamental difference. The only one I can see is the argument about controlling interest, which means the stocks have some value since if you own enough of them, you can influence the company.

None of this means, of course, that I believe the stock market will collapse or that everyone will one day wake up and realize it's all a hoax, or anything silly like that.
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Re: A few very basic investing theory questions that have bugged me lately

Postby Ari » Thu Jan 12, 2017 4:54 am

rbaldini wrote:I'm glad you are bringing this up.

For me, it's even worse: I don't even really understand the value of dividends. When I get a dividend, the price of my stock falls by just the same amount. So... nothing has happened. This means that, as far as I can tell, pretty much the only reason I buy stock is because I will be able to sell it later for a higher price - whether it pays a dividend or not. If prices don't go up between dividends, I make no money at all. Surely I'm missing something, but I don't know what it is.


The stock falls by that amount, but the value of the stock isn't where the dividends come from. The dividends come from the earnings of the company. The company earns money, then it pays some of that money out to you. As long as it keeps earning money, it'll keep paying that money out.

The stock price is also based on the amount of money the company has, which is why it drops at dividend time, but that's a separate issue. The stock is worth money because it's a money machine. Since they payouts are irregular, however, it's only natural that the value fluctuates based on how close the next payout is. But the stock price could, in theory, drop to almost zero and the company could keep paying out dividends if it's still making money, because the dividends don't come from the stock price, but from the earnings.
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Re: A few very basic investing theory questions that have bugged me lately

Postby Valuethinker » Thu Jan 12, 2017 4:57 am

Ari wrote:
Valuethinker wrote:Assuming no tax, then the shareholder is indifferent between the company holding her money in its bank account, or paying it out to her. She still has the same amount of money.

Sure. But if there is no payout, there is no cashflow, which was Nedsaid's argument for why stocks are different from baseball cards.


Back to Modigliani & Miller

In the absence of taxes and agency costs, you don't care as a shareholder.

Your money is still there, it is in the company's bank account but it is still yours (ie belongs to the shareholders in proportion). The company is worth more.

To generate an income from your investment:

- you sell some shares (equivalent to the company paying a dividend in terms of your cash receipts)

- in theory you could also borrow against your stock portfolio and spend that money

In practice, companies that sit on huge cash balances come under pressure to distribute them from corporate raiders (Carl Icahn, Kurt Kerokorian etc.) and activist hedge funds. Or they get taken over in hostile takeovers.

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Re: A few very basic investing theory questions that have bugged me lately

Postby Valuethinker » Thu Jan 12, 2017 5:05 am

dgreen wrote:T - Many people who buy too few shares to be able to make any decisions. And although the company is making lots of money, they also don't get any share of the profits.n.


This is where your logic contradicts Modigliani-Miller.

The cash, and the earnings, are *yours* even if the company doesn't pay them out. Yours in proportion to your shareholding.

You "get" a share of the profits by virtue of owning a share in the company. If the company is in an early, growth stage, you may prefer that the managers reinvest that cash flow to make more gains.

Or for mature companies where the incremental return on new capital investment is lower, companies (tobacco!) may generate surplus cash and so pay substantial payout.

This is precisely how Warren Buffett looks at his personal portfolio. Which happens to be 100% in Berkshire Hathaway shares, a public company. If he finds new and interesting uses for his capital, generating higher returns than his cost-of-capital*, he makes investments- -chiefly these days buying large companies (railroads, utilities etc.) but also in capital consumptive growth businesses (Netjets perhaps). Portfolio investments (AMex, Wells Fargo etc.) he makes very few of, because to make a meaningful difference to the value of BH he has to buy a disclosable stake, and that tends to move the price against him.

When he thinks the share price of BH is below his own estimate of its intrinsic value, he "invests" by paying himself a dividend. To avoid taxation he does that by buying back shares-- excepting tax effects, a share buyback and a dividend payment are equivalent ways of distributing wealth to shareholders.

* his cost of capital is extremely low, due to the presence of a huge insurance interests in BH, and his AA credit rating. In effect he can borrow from the market at say 3% and invest in electric utilities (regulated) and railroads at 7-8%. Because insurance payouts often come long after the policyholder has paid premiums, he has a huge "float" of assets from those premiums that he can invest for higher returns (as long as his actuaries have their loss estimates right-- and he's pretty conservative about that).

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Re: A few very basic investing theory questions that have bugged me lately

Postby nedsaid » Thu Jan 12, 2017 3:44 pm

Ari wrote:
nedsaid wrote:Stocks that don't pay dividends still have earnings and earnings are what you are paying for when you buy a stock.

Baseball players have earnings, too.

Nedsaid: But when you buy a baseball card, you don't have an economic interest in the actual baseball player. In other words, the card does not entitle you to a an ownership of his earnings stream. A baseball card can be pretty valuable but it is a whole different thing than a stock. It is a collectible as opposed to a share of ownership in a company.

I'm not trying to be snarky. I think there's some truth to the comparison between non-dividend paying stocks and baseball cards.

Nedsaid: Non-dividend paying stocks still have earnings. Markets aren't stupid and value not only the future estimated earnings stream but also cash on the books. If a company retains its excess cash rather than pay it out to shareholders, the value of the investment to the investor remains the same. In other words, the shareholder retains the value of the excess cash: if the company keeps it the cash is reflected in the price of the stock; if the company pays out a dividend, the price of the share will drop by the amount of your dividend and you will get the cash.

The main difference is that stocks are much more popular, everyone agrees on their value, there are clear, traditional ways of valuing them that most everyone agrees on, etc. But unless there's cash flow going to the stock holder, I don't see a fundamental difference.

Nedsaid: The whole point is that the cash flow doesn't have to go to the stock holder in order for him or her to benefit. Again, you are buying a set of cash flows and not a collectible.

People don't agree on the valuation of stocks and that is why you have a market. There is a literal army of security analysts out there whose job is to determine the proper pricing of securities. But the price is set by the matching of buy and sell orders at a price that buyers and sellers agree.


The only one I can see is the argument about controlling interest, which means the stocks have some value since if you own enough of them, you can influence the company.

Nedsaid: I don't think you understand what a stock is and how the markets work. Stocks have an economic value as you have a share of ownership in a real company, with real people, real assets, real earnings, etc. You have something real and not monopoly money or a plastic house on Park Avenue. A stock is a share of ownership in a real income producing company. It is not Monopoly, not gambling with chips, and not a computer game.

None of this means, of course, that I believe the stock market will collapse or that everyone will one day wake up and realize it's all a hoax, or anything silly like that.
A fool and his money are good for business.


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