What Are Stocks?
What are stocks?
I know you’ve heard about them, the stock market is always on the news. It makes fortunes and failures. But what are stocks? Why do people buy them? And why do they have value?
Stocks represent ownership in a business. For example, lets consider the company Alphabet (Google for you stubborn folks). Alphabet has about 712 million shares of stock issued. That means that each share of stock represents a 1/712,000,000th share of ownership. If you owned 1,000 shares of Alphabet stock, you’d own 0.00014% of the company! Cool!
As a business owner, you have a claim on the profits of the company – as does every other shareholder.
When a company distributes profits to shareholders, these distributions are called dividends.
But a company usually won’t pay out all of its profits to shareholders. For mature companies, a portion of its profits are invested back into the company. For young companies, no dividends at all are paid; all profits are reinvested back into the company.
So owning stock is basically becoming an investor in a business. How do you figure out what to pay for a stock?
We’ll tackle this subject in greater detail down the road, as it is very complex. But we can sum it up in a few simple sentences:
- Stock prices are based on the future earnings of the underlying company.
- Stock prices adjust when expectations of those earnings change.
- For a given level of earnings, faster growing companies will have more value than slower growing companies.
Let’s pretend that your neighbor has a bakery that earns $100,000 a year in profit, and he reinvests all of the profit back into the business. The business has one hundred shares of stock issued, and he’s willing to sell you half of them, making you a 50% owner. What is that stock worth?
I’ll skip the equations, but if you are hoping to earn 8% on your investment, and you expect the business to earn $100,000/year for eternity, one share of stock would worth $12,500. Now this assumes that the company isn’t growing. It assumes that sooner or later you, as 50% owner of the business, will tell your neighbor, “Look, neighbor. I think it’s time you stop reinvesting all of the profits into the business and start paying me a dividend.” Or, you could always sell the shares to someone else. As long as they have a required rate of return of 8%, just like you, then those shares will still be worth about $12,500.
Now what happens to the value of your stock if one year later the bakery begins to grow, and is expected to grow continuously? If the bakery grew at even a small amount, say, 3% per year, the value of your stock would increase to $20,000/share!
When expectations about a company’s growth change, the value of its stock can change drastically.
What about a 6% growth rate? We originally said, for a given level of earnings, faster growing companies will have more value than slower growing companies. At a 6% annual growth rate, the stock in your neighbor’s bakery would be worth $50,000/share!
Now, paying money for stock is all well and good, even if you’re not receiving dividends. But know this, the value of stock rises as earnings and growth rise because of the probability that dividends will be paid in the future. You may not get paid today, or this year, but sooner or later the stock you buy should start issuing dividends. It is the claim on this future cash flow that drives the value of stock.
You may be able to buy a small company today for a few dollars a share that will grow into a very large company in ten or twenty years. When it becomes a large company and its growth opportunities dwindle, it will have much more cash to pay out. As the company grows and as the size of the potential future dividends increase, the value of the stock increases likewise.
The next time you see something in the news about stock prices fluctuating, you can now think to yourself, “hmmm, I bet the market’s expectations of growth has just changed.” And you’ll probably be right!
Do you have a question, or would like me to cover a particular topic, feel free to leave a comment below!