The stock market is a part of most everyone’s daily life to some degree or another. Even if it’s just getting a daily update on the Dow Jones on the television news, it’s there. And for a significant portion of the country, investments used for retirement accounts or paying for a child’s college education rely heavily on stocks.
But what IS a stock? When we’re buying and selling shares, what is it that’s actually changing hands?
The answer is actually very simple. And while understanding what the intrinsic value and purpose of a share of stock really is isn’t really important to planning for retirement or even in maintaining a strong portfolio, knowing what these transactions really have underlying them is still worthwhile for any investor.
Because, at its core, the concept of stock and public ownership brings a level of democratization to capital markets that, depending on your perspective, is actually quite refreshing. For all that’s made of the idea of monolithic, faceless corporations, the simple fact remains that those corporations are owned by members of the public.
The first thing to understand about stock is that the term “share” is completely literal. A public company is one that has been broken into millions of pieces and then sold off one piece at a time. When you own one “share” of stock in a company, you are a part owner of one (usually) equally-sized piece of that company. If a company has 1 million outstanding shares and you own one of them, you’re the owner of one millionth of that company.
Let’s use a hypothetical example: Acme Corp. is a publicly traded company that caters to bird-hunting enthusiasts with unique equipment for snagging particularly tricky prey; equipment like anvils, rocket skates, or catapults. Its float (a fancy term for how many outstanding shares of stock a company has) is 100 million shares. You are the proud owner of 1 million of those shares, or 1 percent of the company.
But what does that really mean? Can you walk into any of the company's warehouses and say "Hey, it's me, I'm here for one percent of the anvils. They're mine and I have these stock certificates to prove it." No, certainly not. While your ownership is very real, it doesn't come with that sort of direct control lest every public company be paralyzed and unable to operate because of its myriad stockholders exerting fragmented control. No, the actual tangible, quantifiable benefits of stock ownership are much more indirect.
For starters, if the company were to liquidate, you would get 1 percent of that value. So, say the shareholders for Acme decide to hang it up and call it quits. They sell all of the company's assets. If, at the end of that, they had collected $10 million, you would get $100,000.
But that basically never actually happens.
None of the companies currently trading on the NYSE or Nasdaq are moving shares to people who are planning on cashing in when the company goes under and liquidates. In fact, if you've spent any time observing the stock markets, you may have noticed a strong tendency among investors to buy stocks in companies that they believe to be successful or likely to be successful in the future.
So, clearly, the potential for future payouts in the event of liquidation is a part of what makes a stock valuable, but not one that has any real practical bearing on stock ownership..
However, there’s a second piece of intrinsic value to your shares that factors in in a much bigger way: voting rights.
Publicly traded companies convene shareholder meetings at least once a year. At these meetings, shareholders get to vote on the Board of Directors: the small cadre of people who actual run the company. Each share (usually) translates to a vote, so your 1 million shares entitle you to 1 million votes. If you have any strong opinions about how the company should be run, you’re in a position to exert some influence over those decisions by voting for a board member whose outlook on the company matches your own.
But, once again, voting rights are rarely the primary motivating factor for owning stock. For instance, while your 1 million shares entitle you 1 million votes, financier Coyote E. Rockefeller owns 51 million shares. So, even if you and every other shareholder of Acme join forces to stack the board against him, his shares will allow him to elect the majority of the board and, subsequently, maintain control of the company.
And, even in cases where there isn’t a majority shareholder, most people’s voting rights represent such a small portion of the total that it hardly matters. When John Q. Public buys up 1,000 shares of IBM (IBM) , he can’t expect to wield any real influence over the company. That falls to major shareholders with huge stakes like Warren Buffett.
And, in some cases, companies will issue classes of stock that have no voting rights, a way of issuing more stock without having to worry about diluting voting shares too far.
So Why Own Stock?
But this raises a serious question: why own stock? If you’re talking about non-voting shares of a massive company that has little to no chance of ever liquidating, what’s the point in ownership?
The answer lies in the stock markets. While the underlying value of stocks means next to nothing to the vast majority of the investing public, they are what provides the shares with value. Even if the voting rights to your 1 million Acme shares don’t really matter to you, they do matter to corporate raider Coyote E. Icahn, who’s trying to seize control of the company.
So, if Coyote E. Icahn is willing to pay money for the shares, that gives them a specific and tangible value. If nothing else, you can sell them for what the market is willing to pay, and, of course, once you start to multiply owners and interested buyers a few million times over, the value of stocks starts to take off on its own, even if the core underlying source of that value quickly becomes a distant memory.
And the ability to buy and sell pieces of a company is precisely what ultimately makes the stock market (and, to a lesser degree, our entire economy) tick. Because you didn’t buy 1 million shares of Acme to cast meaningless votes at the shareholders meeting. No, you bought 1 million shares of Acme because they cost $10 a share now and you think someone will pay $20 a share next year. And, if you’re right, you can sell your 1 million shares and make a $10 million profit.
And that’s all you really need to know. In fact, that’s all the vast majority of the investing public really needs to know. While a select handful of major buyers of stock may plan on using their voting power to influence a company’s direction, almost everyone else is trading the stock just like they would a commodity.
And that's part of why even non-voting shares ultimately carry value. While lacking the more tangible value profile of voting shares, they are still a piece of the ownership of a company. And if that company is profitable, you're buying a piece of those profits even if you don't have any say in where they go. Which brings us to...
Of course, there is another reason for owning stocks: some companies take a portion of their profits and pay them back directly to the shareholders in cash in what’s known as a dividend.
Take Acme, for instance. When the company was first starting out, it was an exciting time for bird hunting technology. The iAnvil was taking the market by storm, the next generation of catapults was just around the corner, and coyotes across the Southwest were eagerly anticipating Acme's next move. During this period, Acme was posting increasing revenue and earnings quarter after quarter. Excited investors were happy to plop down more and more money for shares because they would increase in value every time Acme reported that their revenue or profits had increased, which was all the time. As such, shareholders were happy to see Acme reinvesting all of its profits into the company to keep finding new ways to increase revenue and keep that stock climbing.
Cut to ten years later: Acme continues to make money hand over fist, but it’s reached a level of saturation in the anvil and catapult markets that would indicate that it’s unlikely that profits will only increase incrementally from here on out. Aside from some token R&D investments, there just isn’t a way to invest the money coming in that will boost Acme’s market share. The company has clearly plateaued.
No big deal, right? There’s still plenty of profit rolling in even if it isn’t regularly increasing.
Not quite. For most investors, the only value of Acme’s stock was that it was increasing in value. If the company just holds steady moving forward, the ir only incentive for holding the stock has evaporated, prompting them to sell their shares. And, if enough investors see it this way and all start selling their shares, the company's value will start to plummet - i.e. if the stock’s not going up anymore, it’s going to go down.
So, companies at this stage in their growth need to do something to maintain their value. They have oodles of money piling up but nowhere to spend it that will keep growing their profits, and they still need to find a way to continue creating value for their shareholders lest their market value plummet. Whatever do they do?
The solution is actually remarkably simple: you just give all that money back to the shareholders. This is what's known as a dividend. They're typically paid out once every three months (known as a "quarter" in financial speak), though dividends that are once monthly or once annually aren't uncommon, and they're expressed in terms of money per share.
So, say Acme's earnings, after taxes and expenses and what not, have plateaued at about $100 million a quarter, give or take depending on how volatile the anvil market is that year. That's essentially $1 for each share in its float. Acme might decide to start paying a quarterly dividend of $0.25 a share, an amount that can be maintained through lean times and still leaves plenty of cash on hand for any new opportunities that do crop up.
Now, holding your 1 million shares has a pretty clear value beyond just waiting and seeing if the stock increases in value. Now, holding your 1 million shares of stock means you're getting paid $250,000 in cash once every three months. In a lot of ways, this is a better value proposition than you had before. Unlike the market value of the stock, which can shift up or down at the drop of a hat, the dividend is a consistent revenue stream for shareholders.
And, more importantly, the value this provides to shareholders shores up the stock's price. People will be willing to pay more for shares when they can feel confident that owning them will mean regular cash payments. So now, steady reliable profits aren't a liability just because they don't increase. Now they mean the dividend is that much more reliable.
Profits Are Used to Benefit Shareholders, but How is Often a Matter of Debate
This also keys into a final reason for owning stocks, whether they're voting shares or not: you're a partial owner of that company, so you're also a partial owner of any profits. Whether those profits are getting reinvested to increase the market value of your shares or paid back to you directly in the form of a dividend, it's your money and it's being used to benefit you.
And this is where voting rights can come back into play in a big way. Just how much of a company’s profits should be used is often a matter of some debate. Activist investors like Coyote E. Icahn may want the money returned to them, but owner Coyote Rockefeller may see more opportunity for growth and want to reinvest profits. In the end, holding more votes allows one to exert more influence over that decision.
And, while you can count on the board's motives being in the right place (board members are almost always major shareholders themselves, so you can be sure they're very much interested in growing shareholder returns as much as possible), that doesn't guarantee its members/directors going to make the best decisions.
Public Ownership Means Ownership by the Public
Whatever a company decides, being a publicly traded company means it exists solely for the benefit of its shareholders. Public companies have a legal obligation to act in a way that benefits their shareholders, they’re legally required to remain transparent about their finances, and they’re run by elected officials.
So, imperfect as it may be at times, the broader system of stock ownership is about opportunity more than anything else. It’s a method of entry into the creation and expansion of wealth and capital for any and everyone who has a mind to be in the fray. And, for all its faults, it creates a system of enterprises that’s more open than would exist without it.
So, the next time you hear someone quoting back the day's movements from the major stock indices, maybe stop and listen. While it may seem like you're on the outside looking in, that doesn't mean that the chance to take part isn't sitting there waiting for you to seize.
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