Wednesday, December 3, 2008

What's the purpose of owning stocks?

Something I was thinking about the other day...what is the value of stock in a publicly traded company these days? According to the wise people at wikipedia:

A share of stock is one of a finite number of equal portions in the capital of a company, entitling the owner to a proportion of distributed, non-reinvested profits known as dividends, and to a portion of the value of the company in case of liquidation.

But these days, companies don't really pay dividends. I think this trend started during the tech bubble, when people still bought stocks even when there wasn't any revenue, and therefore there weren't any dividends...so other companies said "wait, what? We don't have to pay dividends?"

So the only value to a stock is if the company is liquidated (or sold). If the company is liquidated in the usual sense (bankruptcy) then the stock is worthless.

It seems to me that the only reason to buy stock (in most companies, where you don't have any voting rights to determine the direction of the company) is to speculate that the value will go ever upward. This sounds a lot like the foundation of sand underneath the financial crisis, that everything would be fine as long as house prices went up forever. And if they didn't? Well, we didn't even contemplate what would happen.

I am certainly no economist, and the more I read the less I understand. But it's another sign of the way our whole economy has divorced itself from producing anything, and is more about moving money back and forth and making money by taking a cut of every transaction. That can't bode well.

8 comments:

Kayhan Gultekin said...

I don't think it's a foundation of sand. You could look at it as another form of currency. What is the value of that stack of Benjamins that you have in your wallet? Can you trade it in for gold at Fort Knox?

I'm no economist either, but if you were paid a nice dividend from a company whose stock you own, it seems like a smart thing to do would be to re-invest that money in the company that is doing well enough to pay dividends. If it is done for you automatically, then you can just sell your stock to someone who wants it.

Eli said...

First: I 100% agree that owning stocks, and valuation of stocks, makes sense if they pay dividends.

It's the stocks that _don't_ pay dividends (even if they're profitable, eg., Google) that make me curious. (And these are more and more common.) I suppose you're right that it might be best to think of them as another form of currency, but it's a relatively illiquid currency that's prone to violent swings purely due to speculation. Like an emerging market currency that gets bid up and up and eventually crashes. (see: Asia, Latin America, etc.)

I suppose it's that a stable currency (say, the US Dollar, knock-on-wood), even if it's not based on a gold standard, has a stable value and can be traded for goods and services ("ooh!" in the words of Homer Simpson). But I'm not trying to profit based on the fact that the dollars in my pocket are going to rise in value due to somebody else bidding them up.

Becky said...

I think if you have a well-rounded stock portfolio, then it does make sense to buy some stock in a company that isn't paying dividends. Crazy day-trading aside, stocks are supposed to be long-term investments, so why not buy stock in a company you like or believe in, with the thought that maybe ten years down the road it'll start paying dividends?

The caveat is that I have what is approximately a 1970's-era understanding of the stock market (thanks, Dad!). With day-trading, computer models, stock options as salary (did that peak with the dot-coms?), decreased dividend payouts, and crazy bear markets, I really don't see how it's the wisest long-term investment.

Kayhan Gultekin said...

I agree with you. Stocks are not as liquid as cash on hand, but they are not that different from cash in a savings account before online banking (in terms of liquidity). And while you can't exchange stocks for goods and services (CEOs paid in options aside), you can trade them for cash (M-F 10-4pm), which can be traded for goods and services.

And while US$ is more stable, you can still play the same speculation by trading dollars for euros, pounds, and yen.

I think that the liquidity of stocks makes up for the lack of dividends. I agree that the pretense of owning a share of the profits that the company makes is fuzzied, but it still works the same way (effectively): you can get more money when your company makes a profit.

E.g., the althernative is to invest $X in company ABC. When the stock price goes up, your stock becomes worth $(X + p). You can then sell $p worth of stock and keep the "effective dividend".

Jin said...

Dividend is not paid if the company can convince its shareholders that instead of giving out cash, they would get more value by letting the company use the cash to grow the business.

Basically, Google shareholders agreed that instead of taking $50B (or whatever their cash reserve is) out as cash and each shareholder investing on their own, Google can use and grow that cash better on their behalf...

Or something like that. I learned it a long time ago in a finance class...

eldan said...

Are the googles of the world telling shareholders that they will never pay a dividend, or just that it's always jam tomorrow? If the latter, then I guess it's just a matter of the long-term promise of future earnings underpinning everything else. If the former, then it makes no more sense to me than to you.

Becky said...

Eldan, I don't own any stock, so I have no idea. I imagine it shows up in the shareholders' reports -- future projections of how the stock will perform, and if and when dividends will be paid.

Eli? You've owned stock, yes? Did you ever actually pay attention to it?

Eli said...

I thought I linked to this, but I guess not. In particular, Google says that they "have never declared or paid a cash dividend nor do we expect to pay any dividends in the foreseeable future."

I guess my curiosity really is about how today people buy shares in companies even if those shares come with (effectively) no rights whatsoever, no actual access to the profits, etc. They've become "shares" in name only. On the other hand, as I added in my recent post, when the company has a share buyback that is another way that links the value/profits of the company to the shares in that company.