What are stocks, and should you invest in them?

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Ready to invest in the stock market? Make some extra cash by buying low and selling high? Or perhaps go with the vastly more popular, yet unproven method of “buying high during a frenzy and selling low in a panic.”

To improve the odds, perhaps one ought to first understand what stocks are and how they are priced. This will not prevent you from pursuing the second, less productive strategy, but perhaps just make it less likely.

As covered in the prior blog (Corporations: Are they all Evil?), stocks are financial assets that represent shared ownership in corporations.

Corporations are a type of a company, and they come in two flavors, private and public. When an entrepreneur creates a new corporation, it will be of the private type. As enabled by corporate law, seed money from early investors can be exchanged for an ownership stake in the private corporation, in the form of issued stock. The price of this stock will be whatever the early investors and the founders agree it is.

The horse is now out of the barn as this ownership stake can only be reclaimed by the corporation via a stock repurchase. If agreed upon, this transaction will require an expenditure of cash on the part of the corporation, the very same cash that is usually in short supply during the early growth stages of a company.

Which is why the early investors tend to keep their stock.

It is expected that during the early growth stage of a corporation there will be several rounds of cash raised, with more and more stock being issued to investors, often resulting in the situation where the investors as a group now own more of the corporation than the founders. This is not necessarily a negative situation, but it will be reflected in the makeup of the board of directors (the “board”), which represent the shareholders (the owners), thus controlling of the corporation.

Consider the case when such a private corporation becomes profitable and accumulates excess cash. While it is true that cash can be used for many purposes, why shouldn’t the early investors desire a return on their risky investment? After all, they need to make up for their other risky investments that have since tanked. Given the investor representation on the board, a profitable corporation may very well approve the issuance of a dividend, which is cash returned to the shareholders.

A stock dividend is one mechanism, and arguably the most important mechanism, by which the early investors in a corporation realize a return on their earlier, risky investment. If dividends were never paid, then no one would buy stocks, and future entrepreneurs will find it exceedingly difficult to raise early seed money.

Assume that a profitable private corporation with one million outstanding shares of stock decides to issue an annual dividend of $50,000. How does this establish the price of the stock?

Dividing $50K by one million yields five cents per share. If investors knew in advance that an investment in this company’s stock was expected to pay out $0.05 per share per year, year after year, what is the expected price of this stock?

To answer that question, one needs to know what other choices are available to the investors, the ones deciding what to do with their excess wealth. Real estate? Bonds? Other stocks? The Lottery?

Need to start somewhere, so will assume that in this given economy at this time, a relatively low risk investment with an expected annual Return On Investment (ROI) of 5% is competitive when compared to other investment choices. This assumption suggests that the price per share for this private corporation ought to be around $1 per share, because each share would annually generate a $0.05 dividend, which is a 5% ROI per year. A price of $2 would be uncompetitive, while a price of $0.50 would be a bargain.

This rational analysis suggests that the expected price for this stock is somewhere between $0.50 and $2.00. However, the price of stocks and other financial assets do not always price themselves in a rational manner. There are many other factors to consider, including the tendency for humans to be emotional and irrational.

What exactly is the mechanism for setting the price of stocks? Like any other financial assets, it is solely determined by a market which balances the economic forces of supply and demand. For a private corporation that “market” would be the founders and a handful of investors. For a public corporation, the market would be a much deeper public exchange such as the NASDAQ or the New York Stock Exchange.

While it is the economic forces of supply and demand that directly establishes the price, what are the forces on these forces? What are the indirect influencers on the price of stocks?

They would be the stock’s dividend and buyback history, plus the company’s rate of growth, market share, product lineup, competition and management, etc. In addition, there is interest rates, the inflation rate and the overall health of the economy to consider.

Finally, there is the very unpredictable emotional factors, often driven by herd mentality, resulting in volatile peaks and valleys.

As a financial asset, stocks only have value because most pay, or will pay, a dividend. Some stocks do not pay a dividend, but the expectation is that they eventually will, or that the company will eventually be acquired by one that does. Because without a dividend, buying and selling stocks would simply be an elaborate variation of musical chairs.

I apologize if you thought this was going to be some sure-fire, get-rich-quick primer on picking stocks. You will find plenty of those on the Inter-webs, just search for “sure-fire, get-rich-quick stock picker.”

Instead, before you buy a stock, ask yourself a couple of questions:

What is the time frame you will hold the stock? Reconsider this investment if your answer is not in years.

What is it history of dividends and buybacks (similar to a dividend)?

If it pays a dividend, what is its dividend yield? How does compare to other investment choices?

What will you do if the stock price drops 10% or more? Panic and sell?

Do you really think that a good time to buy is right after the stock surged to an all-time high?

If the “experts” are so good at picking stocks, why are they still working for a salary? Shouldn’t they be retired billionaires in Bermuda by now?

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