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What stocks really represent

By David Luhman on Sun, 05/10/2009 - 00:49

What stocks really represent

Financial assets as swaps of money flows

This is important to keep in mind because when you invest in a stock, you're looking for a good total return which is a combination of dividend income and capital gains.

Here's another way to look at it. When you buy a stock, or almost any financial asset for that matter, you're exchanging money in the present for a stream of money in the future.

If you give up $1,000 today to buy a 6 percent, one-year bond that pays interest annually, you're buying more than a piece of paper with fancy printing. You're buying an interest payment of $60, and return of your $1,000 one year in the future.

Future cash flows from stocks

And you're doing the same thing when you buy a stock, but with a stock, the future income stream is more uncertain than with a bond.

Suppose you take $1,000 to buy 10 shares of a stock that yields 4 percent and has a current share price of $100. You plan to sell the stock in a year, when you hope the share price will be $110 per share.

So you're exchanging $1,000 now for a future stream of four quarterly dividend payments that will total $40, and you also hope to get $1,100 with the future sale next year. The problem is that your future returns are less certain with a stock than with a bond.

Cash flows from stocks are uncertain

First, you're dividend payments are not guaranteed. Although it's rare for American companies to cut their dividend payments, it happens all the time.

When IBM had serious trouble in the early 1990s, the new management cut the firm's quarterly dividend from over $1 to less than 25¢. Although a company has an obligation to pay interest, the company has no obligation to pay dividends to common shareholders.

The other thing that is uncertain is the future price that you'll receive for the stock. This price is highly uncertain.

Stocks can be held indefinitely

Now let's look at the price you should pay for a stock. Unlike bonds, most stocks do not have a maturity date. Of course a stock becomes worthless if a firm goes bankrupt, but many stocks have been traded for over 100 years.

In this respect stocks are different from bonds because stocks can be held indefinitely. Let's see how much you might pay for a stock if you held it forever.

Remember, when you buy a stock, you're buying a stream of future cash flows. Suppose you buy a stock that pays a constant dividend of $1 per quarter, every quarter. In this case you're not buying a stock so much as you're buying an eternal stream of $1 payments which arrive every three months.

Since the present value of $1 received 30 years in the future is small, you can approximate the value of the stock by comparing the stream of $1 quarterly dividend payments with the payments offered by a 30 year bond.

With the help of a computer or even a calculator, it's not that hard to decide if the stock, at its current price, or the bond, at its current price, is the better deal. This helps to explain the linkage between interest rates and stock prices.

Valuing a growth stock

Note in this case that the stock offered a constant dividend of $1 per quarter, forever. However, few real stocks offer a constant dividend.

It's more common for a company to pay perhaps $1 per quarter this year, and then increase their dividend to $1.05 per quarter next year. Most firms are able to increase their dividends because of a combination of real growth and inflation-related growth in profits.

If you try to price a stock that has a growing dividend by comparing it to a long-term bond, you've got a bigger challenge. You can still use a computer to help you with the calculations, but now you've to make some assumptions.

If the dividend will grow from $1 per quarter to $1.05 per quarter a year later, you've got a 5 percent growth rate in the dividend. But will this 5 percent growth rate be sustainable, or is 3 percent more realistic? Because of the nature of compounding, which I discuss in my tape on retirement planning, even small changes in the growth rate will make for large changes in the value of the stock.

Valuing a high growth stock

Things are even more difficult if you're trying to value a new, small company. These companies currently pay no dividends. So when you value the stock of a new company, you're trying to see perhaps five or ten years into the future when the company finally will pay a small dividend.

Then you have to look even farther into the future to estimate the growth of that initial, small dividend. In this case, the growth rate may be high, because many small companies grow at 20 percent a year.

But if a small company's growth rate falls from 20 to 15 percent a year, the mathematics of compound growth dictate that the price of the stock will fall dramaticly. This is the underlying reason why stock prices of small growth companies are more volatile than stock prices of more established companies.

Future earnings drive stock prices, not tangible assets

Note also that the most important thing in valuing a company is, in most cases, the company's future earnings potential. The value of the company's present tangible assets may account for a fraction of the stock's price, but a company's current assets don't add much to a stock's value.

In fact, the average stock in the Standard & Poors 500 sells for about four times it's so-called book value. This also is due partly to the fact that book values are based on historical numbers, and inflation has eroded the book values of many assets.

However, in extreme cases, the value of a company's stock is based on the company's assets. I remember the case of a biotech start-up firm which was funded almost totally with equity.

The small firm's future was based on one drug. When this drug failed to get FDA approval, the value of the firm's stock dropped immediately to the amount of cash the company had in the bank. The market had no hope for future earnings, so the company was worth no more than its cash on hand.

Growth stock prices set in the real world

To many people, all this talk about determining the price of stocks may seem too theoretical. There are plenty of people who buy stocks because they like the name of the company, or because the stock has a good "chart pattern", or simply because the company makes good products.

But there are also many people at investment banks and mutual funds who use computers and mathematical models to value stocks based on the future dividend payments offered by the stocks. If the price of a stock strays too far away from this theoretical value, investment professionals will buy or sell the stock until the stock reflects a more realistic value.

This doesn't work all the time, and even professionals are often wrong, but remember when you buy a stock you're not simply buying a scrap of paper. You're buying a future stream of payments.

Of course, your idea of a future payment may be selling tomorrow at a slight profit to a bigger fool. Fair enough. But if the price you hope to sell at tomorrow isn't sustainable by real dividend payments eventually, you might wind up being the biggest fool.

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