Dumb Question

[nicky g]

Why do people trade shares in companies that don't pay dividends? What makes the shares have any value? The prospects of the company or a takeover bidder buying them back one day?

[adios]

It's not a dumb a question at all in fact it's a very astute one.

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Why do people trade shares in companies that don't pay dividends?

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The function of the stock market IMO is set a value for each company. It's kind of a thing where investors have to decide that other investors will be interested in buying shares due to certain financial performance. If a company is growing earnings, then investors may believe that a company will pay a dividend some time in the future but reinvesting earnings in the business will be more beneficial to growing earnings and thus the value of the company. If a company could pay a dividend to investors which is taxed twice (at the corporate level and when paid to the shareholder as a dividend) or the company could reinvest the money that has only been taxed once and acheive a higher return than the shareholder could, typically the shareholder would choose the latter. Also companys buy their own stock which is more tax effecient.

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What makes the shares have any value?

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BadBoyBennie posted the Discounted Cash Flow model for determining the value of a corporate entity based on the present value of future earnings and the present value of current net assets. I don't have any links right now but I'll post some giving some formulas. However, there is a fair of amount of debate on what "earnings" should be discounted and whether or not the present value of assets should be part of the valuation formula for corporations that run in perpituity. Should the "earning" be what appears on the income statement? Should they be the dividends that are actually returned to investors? Should valuation be based on "free cash flow" (BadBoyBenny also posted a definition of what free cash flow is and I prefer using free cash flow)? At anyrate the valuation of a corporation is highly dependent on the growth rate of "earnings" and the discount rate (equity risk premium more or less). Due to the expontential nature of these formulas, valuations can vary WIDELY for individual companys.

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The prospects of the company or a takeover bidder buying them back one day?

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The takeover value should be based on the present value of future earnings, the net assets that would acquired, and the "synergy" benefits involved in acquiring a company. "Synergy" benefits from my experience usually involve streamlining operations i.e. obtaining increased earnings with lower labor costs.

One thing to keep in mind when looking at valuations, is to evaluate the three financial statements; Income Statement, the Balance Sheet, and the Cash Flow Statement.


Currently my portfolion is almost exclusively dividend paying companys FWIW.

[Non_Comformist]

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Currently my portfolion is almost exclusively dividend paying companys FWIW.

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A lot of wisdom in that IMO.

One thing that Warren Buffet has written on is the value of retained earnings per share and his belief ( which I believe history has supported) that these undistributed earnings overtime will show up in a stocks value.

He is also a big proponent of ROE as a measure of whether or not a company has fruitfuly used retained earnings. He also strongly believes that its becomes increasingly difficult for a company to do this using ROE because of the growing base (equity) each year.

[BadBoyBenny]

Nicky,

Adios wrote a much more in depth post than I'm going to, but here is my take.

A lot of people view buying a stock as if they were buying the whole business. If they think the amount of earnings and cash a company will generate over the future (discounted to today's dollars) is worth the risk that business goes bad, then it's safe to assume the stock will go up. Every dollar that a company you own make can be considered a fractional dollar in your pocket, not there to spend, but you have a claim to it.

If the company does make all that money and it doesn't go up, it either will be taken over or will declare a dividend or will buy back stock (so that you own a larger piece of the same pie). Of course, it could be run by crooks who will give your portion away to themselves by overpaying themselves or through stock options, but that is why people should not underestimate mangement that is proven to have both competence and integrity when valuing a company.

It's amazing that about two years ago I was able to buy companies that were trading for alomst exactly the amount of cash that they had on hand when they were cash flow neutral, and ready to start making money. One company I bought actually had more money in cash (with no debt) than its market value.

[GeorgeF]

4 Rational Reasons and one irrational reason to own stock:

1) Present value of future dividends. Look at:
-- Kodak, EK they paid dividends in the past, probably not in the future.
-- Microsoft MSFT did not pay dividends in the past but probably will in the future.
-- Annaly NLY, dividends all over the place
Note the uncertain future of dividends and that I said probably. It might be a good idea to make sure you know how to calculate present values of future payments if you don't.

2) Aquisition value, some large company might buy it from you.

3) Greater fool theory, someone dumber than you might buy your 100 shares of XYZ for more than you paid.

4) All other investment choices are worse. In countries facing a currency crises stocks are often bought just to get ride of cash and other assets before they become worthless.

5) To quote Clint Eastwood, "Do you feel lucky punk, do ya?"

[eastbay]

Wouldn't the same question apply to stamps, beanie babies, antiques, and just about anything that people buy and sell for profit?

eastbay

[GeorgeF]

It is unlikely that you could lease your beanie babies or antiques so there is no income stream from them as their is with stock dividends.

While you own them you can use them and enjoy them. Note that all these things depreciate in value and can be lost stolen or damaged. You have to pay storage costs, maintenance and insurance.

The assumption is that you will be able to sell them in the future for a profit. I personally doubt it. Antiques that fetch high prices are in top notch condition, most people cannot maintain their antiques that way.

Their is a poker analogy here. There are 10 people with identical antique chairs. Over time 9 of them damage destroy or loose their chair. The tenth person ends up with a very rare antique. Antiques, like poker, have few winners. The winners in antiques win in part because of the losses of the loosers. In theory stocks can grow in value without other people loosing their wealth.

[BadBoyBenny]

This is my take on the main distinction...

Collectibles rely purely on perceived value, securities have an underlying intrinsic value. Of course this exact value is relative to individual perception, but it is there nonetheless. While you cannot always sell a security for its intrinsic value, you as an partial owner have a claim to the money that it earns, which is why most successful investors base their investing decisions on some measure of intrinsic value that is determined by estimated cash flows.

I would agree that investing based purely on technical analysis is somewhat similar to invesing in collectibles, as technical traders seem to be buying more on what they think someone will pay tomorrow or in a month than what they think the underlying business is worth. This doesn't mean you can't make money in it, I know people who made thousands of dollars off the beanie baby craze, just a different viewpoint.

[nicky g]

Thanks to everyone for the very helpful replies.

[nicky g]

I don't think so; although there's a great deal of speculation, investment etc in such things, the main reason they go up in value is that people actually want them for a range of reasons not related to making a profit - rarity, beauty, the person is a weirdo etc. The people who are purely speculating on their value are ultimately relying on people who want them for the sake of owning them; people who aren't buying them purely in order to make a profit. The only reason to buy a stock on the other hand is, I would have thought, to make money. Maybe some people do it purely to hang their ownership certificates on the wall or boast that they own a piece of the sharpest dressed company in town, but I doubt it's very many.

[adios]

I almost forgot to post a couple of sites. Well I promised links but these sites are decent IMO and I know they contain valuation models.