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What Grounds Stock Prices?

2016-02-23

There's no math in this one. Sorry.

The Question

I always wondered: why do stock prices go up when a company does well and go down when it does badly? If I made my own exchange where people could buy and sell what I'll call "shtocks" (ownership to pieces of paper with a publicly traded company's name written on them), would people still decide to buy and sell them at higher prices when a company is doing well?

Most stock owners don't actually use their stock to do anything other than sell, so what's the difference between stock and shtock? If there is no difference, then shouldn't we be concerned that the whole stock market is a castle in the sky which could come crashing down? This post is about why stocks have real value.

"Shtocks" have no real value

Markets are all about buying and selling intelligently, so let's assume it's 2006 and my shtock exchange has traders A and B, where A wants to buy some apple shtock, and​ B is intelligent.

Then this conversation is likely to happen:

  • A: I'll pay $10 for 1 share of Apple shtock.
  • B: I'll sell it to you.
Now A is down $10. In year 2016, Apple has grown to be a corporate giant, and A wants to cash out on his piece of paper:
  • A: I'll sell 1 share of apple shtock for $100.
  • A: Hey are you going to buy? Apple is like a way bigger company now.
  • B: Hahaha no.
  • A: What about at $50?
  • A: $10?
  • A: $1?
  • A: Hello?
Trader A never sells, and basically just loses $10. You may protest that in a real shtock exchange, there would be many traders, and that people would buy, trusting that other people would buy their shares later on. However, if everyone were intelligent, everyone would act like B. There is no link between shtocks and the company they represent, so there is no reason why shtock price would change with the company's fortunes.

Anyone who buys shtocks is buying into a Ponzi scheme. They trust that in the future there will be someone to buy their shtocks at a higher price, which is a pretty brave assumption when shtocks have no real value ever. A ludicrous real-world example of people buying stock in a company that did nothing profitable (basically shtock!!) was the South Sea Company. Ultimately countless uninformed people lost their money, while insiders or lucky investors escaped with a profit. In modern day, greater public information generally helps such a market crash from occurring, and laws against insider trading help mitigate such manipulation.

It's also worth noting that the shtock exchange is a zero-sum game; people can only make money by taking an equal amount of it from someone else. At the end of the day, the people who lost money are the ones who payed the most for shtock.

Stocks have value that comes from possibilities that may never happen

Fortunately, something grounds stock prices. Unfortunately, that thing is vague and inaccessible to most individuals, so calamities like the Great Depression are always possible. The reason stocks have value is the potential for a stock to pay dividends or liquidate.

A dividend is a fraction of a company's profits, distributed to its investors, which makes owning a stock pretty worthwhile. For instance, Apple has been giving quarterly dividends for a few years now, so in the last 12 months investors got $2.08 per share. That's about about a quarter of its profits (its payout ratio​ is about 1/4). At this rate, it would still take over 50 years to make up for the price of buying the stock, but you can always sell the stock to the next patient person.

And those companies that don't give dividends, like Google? They have the potential to. The company's money is being reinvested in the company instead - this might sound uninteresting when you're not getting a cut of the profits, but in principle someone with enough money could buy up the stock and then change company policy to pay dividends. Each stock grants a vote in the company's board of directors, and the board of directors decides whether to do things like pay dividends. Curiously, there are few entities in this world capable of actually buying enough Google stock to ensure a seat on the board of about 13 directors. But doing so is not necessary. As long as the possibility of paying dividends is always within arm's reach, a stock's value will grow with profits.

There is only one other, scarier thing that grounds stock prices more concretely - liquidation. When a company decides to liquidate, it will sell all its assets, try to pay off debts, and then distribute whatever money it has left over to investors. Google, for instance, has an estimated value of over $200B in assets it could liquidate in things like cash, investments, land, and facilities. Compare that with its current market cap (total cost of all stock) of about $500B. It wouldn't make any sense for Google's stock price to drop below 40% of what it is now, because in that case the company could liquidate, giving investors more money than the stock is being traded for.

The bottom line: even if liquidation and dividends are unlikely to happen for a century, they are the factors which ground stock price in reality. It still blows my mind that people's choices drive stock prices in a somewhat reasonable manner when, in many cases, ownership of that stock confers no tangible benefit.