Copyright © 2003 by Ian Lance Taylor
This document is licensed under a Creative Commons License.
A company for carrying on an undertaking of great advantage, but nobody to know what it is.
|Prospectus from an anonymous entrepreneur who sold £2000 worth of shares in this company before disappearing forever, in the year 1720.|
Last changed on $Date: 2003/03/28 01:13:07 $.
This is a brief discussion of my thoughts on stock prices. This is based on an e-mail message I wrote in early 2000, near the top of the bubble. At the time it was clear to me that many people failed to understand how stock prices really worked. Now that the bubble has popped I think people have a better understanding of stock, but perhaps some will still have something to learn here.
Note that there are plenty of smart people who disagree with the views taken here, so don't take it too seriously. If you hurt yourself, it's not my fault.
Some of this discussion is specific to the U.S.A. I'm not very familiar with stock markets in other countries.
Most people buy stock in hopes that they will make money. There is a great deal of opinion available as to which stocks will make money--on the net, on TV, in books on investment. I believe that most of that opinion is misleading.
It is misleading because most discussion of making money with stock focuses on information which is not inherently important (e.g., P/E ratio, technical analysis, etc.). I want to stress the word inherently here. I'm not saying that this information is not important; however, its importance is not inherent in how stock works. It is important because it is important to other people. It is not important in and of itself.
Stock prices are a consensual hallucination.
To see what I mean, let's consider the different ways stock can be used to actually make money.
You can sell the stock to somebody else for more than you bought it for.
Some stocks pay dividends. These are payments of cash or additional stock made to existing shareholders. Many established companies pay these quarterly. Many high-tech companies--the very companies which led the recent bubble--do not pay dividends.
Occasionally a company will be purchased for cash, in which case all existing shareholders of the purchased company will receive some money based on the number of shares they own. (More frequently, companies are purchased for stock, in which case shares of the purchasing company are exchanged for shares of the purchased company.)
If you want to make money on stock, those are your only paths. You can make it quite a bit more complex by using options and derivatives, but these amount to different ways of betting on the movement of stock prices. They don't get you out of the hallucination.
Let's start with dividends. Occasionally people argue that the price of a stock is based on the future dividends which it will pay, with some discount rate applied because the money will arrive in the future. This turns out not to be the case.
Purchasing a stock which pays dividends can be thought of as similar to purchasing a bond which pays interest. In both cases you pay a certain amount of money, and you periodically receive cash. A bond typically has a maturation date, at which point you get back your original investment (there are many variations which are not important here). While stock does not have a maturation date, you can sell it at any time, and hopefully recover your original investment.
The difference between stock dividends and bonds is, of course, that bonds provided a guaranteed return on investment, and stocks do not. A company may pay a smaller dividend, or it may stop paying dividends entirely (or it may pay a larger dividend). When the bond matures, you recover your original investment. If the stock price goes down, you do not (or, if it goes up, you get more).
In short, bonds have specified behaviour. Stocks do not. (We'll ignore the case of risky bonds, such as junk bonds; it's possible to buy bonds which are clearly less risky than any stock, such as U.S. Treasury bonds, backed by the U.S. government.) In other words, stocks are more risky than bonds: there is a greater chance that you will lose money. When one investment is riskier than another, we normally expect the riskier investment to have a higher rate of return. The higher rate of return compensates for the greater risk of losing money.
The average yield on stock dividends over the last 80 years is 4.39%. In other words, on average, if you bought stocks and never sold them, it was equivalent to buying bonds which paid 4.39%. However, the dividend yield has dropped steadily since 1982, down to as low as 1.07%. While it has rebounded slightly in the new millenium, it remains below 2%.
By comparison, the yield of long term U.S. Treasury bonds since 1982 has been consistently over 4.5%.
In other words, these days, you can make more money investing in long term U.S. Treasury bonds than you can from stock dividends, on average. This hasn't always been true, but it has in fact been true since about 1965.
This does not necessarily mean that bonds are better than stock. After all, stocks can go up in price. What it means is that the price of a stock is not based on the dividends which it pays. Paying dividends probably increases the price of a stock. But if dividends were a significant component of stock price, then the dividend yield would be at least close to the yield on long term U.S. Treasury bonds.
And, of course, these days many stocks do not pay dividends at all. This is further proof that stock prices are not based on dividends.
It is conceivable that part of the price of a stock is based on the possibility of a cash purchase of the company.
Companies do get acquired fairly often. However, most acquisitions of large public companies are done using stock. Some price is set on the acquired company, and the acquiring company issues that amount in stock, based on the acquiror's stock price. That does not set a real value for the stock price of the acquired company; it only sets a value in terms of the stock price of the acquiring company. So this type of acquisition does not help us see how stock prices are set in general.
The possibility of a cash acquisition does set a lower bound on the stock price. If the stock price of a company is low enough that the total market capitalization of the company is less than the total value of the company's assets, then it makes sense to purchase the company for cash, and sell off the assets. This can be done even with a very large company by borrowing the cash used to make the purchase; this is called a leveraged buyout.
Moreover, if the company generates enough cash, it may make sense to purchase the company for cash, keep running it, and simply collect the profit. This is the underlying basis for the commonly cited P/E ratio, which divides the price of the stock by the company earnings (i.e., net profit). If you assume that earnings will hold steady (not generally a safe assumption) then a P/E ratio of 15 implies that for an outlay of $15 you could get $1 each year, which is a return on your investment of 6.67%. Of course, buying a company would be a relatively risky investment. Still, this suggests that a company with a low P/E ratio is a candidate for an aquisition, and might therefore be a good investment (because the acquiror will normally have to pay somewhat more than the trading price to buy up all the shares).
In fact, the average P/E ratio of the overall stock market over the last 80 years was 15.7. On June 30, 2002, the average P/E of the S&P 500 was 37, roughly equivalent to a return of 2.7%. So even after much of the bubble has popped, we see that the P/E ratio currently predicts a return which is less than that available from long term U.S. treasury bonds.
The historical figures suggest that the P/E ratio can be used to set the real value of a stock, assuming you take into account other factors like the stability of the company. On this assumption, stock prices are still far too high, and they will inevitably continue to fall.
However, this is misleading. Somebody who focused only on P/E ratios would have missed the entire stock bubble from 1996 on. They would have refused to buy stocks even as share prices were going up, and they would have missed the chance to make a great deal of money by selling before the bubble collapsed.
The P/E ratio does give an approximate lower bound on the price of the stock. A company with a very low P/E ratio is a potential takeover target, and therefore a potential good investment. However, the P/E ratio does not give the correct price of a stock because it does not set an upper bound on the price. The upper bound on the price is set only by the willingness of people to buy the stock. This was clearly shown in the recent bubble.
Thus we see that while the possibility of a cash aquisition does permit us to set a lower bound on the stock price, it can not be used to determine the real stock price itself.
So far, I have argued that dividends and potential acquisitions are not significant components of the price of a stock, at least not given present stock prices. However, people clearly do buy stocks, and they clearly do expect to make money by doing so. There is only one way they can make a reasonable return on their investment: by selling the stock to somebody else at a price higher than they bought it for.
Let's take a moment to think about this. Suppose you buy a share in the Frobozz Stock Company for $10. You could have put that $10 in a savings account, or just bought a pizza, but you didn't, so you would eventually like to get more than $10 from your share. The only way you will do this is by selling your share to somebody else for more than $10 (in fact, you want to sell it for more than $10 plus the interest you could have gotten in a savings account, or a bond, or whatever).
You might think that the Frobozz Stock Company is a good investment because it has two "z"s in the name (bear with me for a moment). When you go to sell it to your friend Adam, you'll talk about what a great buy it is because it has two "z"s. Unfortunately, he might not care about "z"s. You would have to find somebody who does care.
Or you might think that the Frobozz Stock Company is a good investment because it has a low P/E ratio compared to its competitors. When you go to sell it to your friend Beth, you'll talk about what a great buy it is because it has a low P/E ratio. Unfortunately, she might not care about P/E ratio--just because it makes sense to you doesn't mean that it makes sense to her. You would have to find somebody who does care.
As it happens, a lot of people do care about the P/E ratio of a company. But we can see that the only thing which really matters about stock price is whether you can convince somebody else to buy it from you at a higher price. The P/E ratio does matter. However, assuming the stock price is above the lower bound discussed above, it only matters because it matters to a lot of other people. It is just an agreed convention for setting the stock price.
If everybody suddenly stopped caring about the P/E ratio, and instead started caring about, say, the number of "z"s in the name, then stock prices would shift. They would shift because people would be willing to pay a higher price for some stocks, and a lower price for others. But nothing about the companies involved would have changed. The only thing which would have changed would be people's perceptions of how stock prices should be set.
This is what I mean when I say that stock prices are a consensual hallucination. The things which matter in setting a stock price only matter because many people think they matter. If people changed their minds about what mattered, stock prices would change, even if nothing else changed.
Before I wrap up, I want to briefly discuss another aspect of stock: ownership. Owning stock in a company is often described as owning a portion of the company. It is possible that this ownership is desirable, and should be part of setting the stock price.
Unfortunately, the notion of owning stocks as owning a company is misleading for ordinary small investors. If you do not own a noticeable percentage of a company, the things you can do are, in practice, limited to:
Writing proxy proposals, which are voted on once a year at the annual meeting.
Voting on proxy proposals written by shareholders or management.
Voting for the members of the board of directors.
This is, in theory, real power. In practice, a significant number of the shares of any given large company are held by management and by large investors who tend to vote with management. It is difficult, though not wholly impossible, to pass a proxy proposal over management objections. Moreover, since proxy proposals are only voted upon once a year, they are a very blunt instrument.
Voting for the board of directors seems promising, but most companies offer only one choice for each position. It is possible to write in somebody else, but only a very well-funded opposition candidate is likely to be able to reach and convince enough shareholders to get elected. It's very unusual for anybody other than the management supported board members to be elected.
There is nothing wrong with buying stock in a company because you like the company. You'll get a copy of the annual report with some nice pictures, and you'll get invited to the shareholder's meeting. But for that, buying one share would be just as good as buying one thousand.
I've argued that stock prices are largely set by shared conventions. What lessons can we learn from this?
Is it a mistake to buy stock? No. History shows that stocks can often be a good investment. You should just understand clearly what you are getting into. You should look for stocks which pay a good dividend yield, if you believe that the company will continue to pay good dividends. Or you should look for companies which you believe will be acquired for cash. Or you should look for companies which you believe that other people will see value in.
Should you ignore P/E ratios and other such information? No. Since you want to eventually sell your stock to other people, you should think about the things which other people care about. However, there is a clear shift in emphasis. Instead of thinking "the low P/E ratio means that this is a good buy," think "the low P/E ratio is something which other people care about, and suggests that they will think that this is a good buy when I want to sell." Following this approach means that you have to pay attention to what other investors are thinking about, so that you can shift your plans accordingly. To be really successful in your investments, you should try to anticipate what people will care about in the future.
What about technical analysis? Technical analysis essentially means looking at past price movements to predict future price movements. If everybody bought stocks more or less at random, that would be an approach as good as any other. But people buy stocks because they think they will go up in price for various reasons. You should pay attention to those reasons, not to the way the price has changed in the past. Actually, technical analysis is interesting in this sense: if a lot of people use it, then you could use it too to predict what they think about stock prices. Since I'm arguing that the goal of a really successful investor is to predict what other people think will happen to a stock, technical analysis might be a useful tool. I don't really know how many people really use technical analysis, though.
Why do stock prices tend to go up over time? Actually, although the U.S. stock market has historically gone up, it's worth nothing that this is not true of all stock markets. Many stock markets have gone down over time, or more or less stayed even, after correcting for inflation. The U.S. stock market tends to go up because the U.S. economy has historically expanded over time due to increasing productivity, and because the U.S., with a historically stable financial climate, attracts a great deal of foreign investment. The overall effect is that, even after correcting for inflation, there is more money in the stock market over time, which drives prices up on average. And it's worth remembering that although the stock market has consistently gone up over time, there have nevertheless been long periods, lasting many years, where it has gone down before recovering. If we are in one of those periods now, then most stocks would be a good investment only for somebody both patient and young.
Do I have any hot stock tips? No. All my investments are handled by my financial advisor.
Thanks for comments from Jonathan Mark.