Question on the nature of the value of shares

[tothemax6]

Hi all,
I have a question which has been bugging me for a while, hoping to get some thoughts from those who know more about shares.
The question is, what actually gives a share its value? Initially, my impression (before I actually bought some shares) was that dividends were what gave the shares value. Makes sense, in the same way that interest gives a term-deposit value. However, it appears that a large number of shares have no dividend. Also, major shares which do have dividends often have negligible returns - often less than inflation.
So of course the only answer to this is 'the value of shares comes from the potential capital gains'. This I cannot understand, although it does appear to be the main reason people buy shares. When one gets capital gains, it is typically because the asset becomes more valuable. As an example, I buy an ounce of platinum, changes in industry cause increase demand for platinum raising its value. Or as another example, I buy a house, people decide to move into the neighbourhood, increasing demand for the house, raising its value.
However I cannot see the way in which a share without a dividend has any underlying value, in the same way that a house has value or a pound of rice has value. It seems that the value is purely manufactured by the bidding process, and that the only 'capital gains' that are possible come from those bidding up the price in search of capital gains (a circular process).
Please enlighten me, I am very lost
Cheers!

 

[Synergy]

When you buy a share, you are buying a very small part of a company - You become a part owner of that company. The company has value, so the share also has value.

 

[skc]

Hi all,
I have a question which has been bugging me for a while, hoping to get some thoughts from those who know more about shares.
The question is, what actually gives a share its value? Initially, my impression (before I actually bought some shares) was that dividends were what gave the shares value. Makes sense, in the same way that interest gives a term-deposit value. However, it appears that a large number of shares have no dividend. Also, major shares which do have dividends often have negligible returns - often less than inflation.
So of course the only answer to this is 'the value of shares comes from the potential capital gains'. This I cannot understand, although it does appear to be the main reason people buy shares. When one gets capital gains, it is typically because the asset becomes more valuable. As an example, I buy an ounce of platinum, changes in industry cause increase demand for platinum raising its value. Or as another example, I buy a house, people decide to move into the neighbourhood, increasing demand for the house, raising its value.
However I cannot see the way in which a share without a dividend has any underlying value, in the same way that a house has value or a pound of rice has value. It seems that the value is purely manufactured by the bidding process, and that the only 'capital gains' that are possible come from those bidding up the price in search of capital gains (a circular process).
Please enlighten me, I am very lost
Cheers!

In theory you are correct. If a company never pays dividend or return cash to shareholders than the value of the company is zero. Since what good is $100m cash sitting in the company if you were NEVER going to be able to get your hands on it?

In practice, company rises in value because what it owns can make more money than before. It is highly unlikely that the money will be trapped inside the company forever. And in those circumstances you will find that the market will mark down the share price (comapred to the company's assets or even cash), or some active shareholders will pressure management to give back the cash.

And in terms of "value" being manufactured by the bidding process... perception is often reality. And isn't that just the same as the house or bag of rice example you've mentioned? What is the value unless someone is willing to buy it?

 

[Tanaka]

I just completed reading Roger Montgomery's book 'Value Able'. The book teaches how to find the intrinsic value of a company. Most companies on the ASX and any market for that matter trade above their intrinsic value. When you buy a stock you are buying part of a company (it'ss assets, income and debt), it doesn’t matter if they don’t pay a dividend as long as they are using that money to grow at a better rate than you can find in a bank account or property. There is a thread about Roger Montgomery on in this forum. Have a look at his website rogermontgomery.com. IMO The reason most stocks trade at above their intrinsic value is that people are speculating about future performance of the company.

 

[Tysonboss1]

Hi all,
I have a question which has been bugging me for a while, hoping to get some thoughts from those who know more about shares.
The question is, what actually gives a share its value? Initially, my impression (before I actually bought some shares) was that dividends were what gave the shares value. Makes sense, in the same way that interest gives a term-deposit value. However, it appears that a large number of shares have no dividend. Also, major shares which do have dividends often have negligible returns - often less than inflation.
So of course the only answer to this is 'the value of shares comes from the potential capital gains'. This I cannot understand, although it does appear to be the main reason people buy shares. When one gets capital gains, it is typically because the asset becomes more valuable. As an example, I buy an ounce of platinum, changes in industry cause increase demand for platinum raising its value. Or as another example, I buy a house, people decide to move into the neighbourhood, increasing demand for the house, raising its value.
However I cannot see the way in which a share without a dividend has any underlying value, in the same way that a house has value or a pound of rice has value. It seems that the value is purely manufactured by the bidding process, and that the only 'capital gains' that are possible come from those bidding up the price in search of capital gains (a circular process).
Please enlighten me, I am very lost
Cheers!

The value of a company is based on the value of the assets it owns and the earnings generated by these assets. A company does not have to pay a dividend to have a value, for example a company could not pay a dividend because it chooses to reinvest it's earnings back into opening more stores and generating further profits.

Picture this, You own shares in coca cola back in the 1900. they have one plant producing coke earning $50,000 / year. they can choose to pay out $50,000 per year in dividends or use the $50,000 per year to build a new plant every 3 years.

obviously the value of the coke company will sky rocket over time as they open more plants and don't pay dividends.

If they were opening a new plant every 3 years, then they would be earning about 33% on any money left in the business, compared to about 6% interest you would get in a bank account if they paid it out to you.

 

[Tysonboss1]

Also, major shares which do have dividends often have negligible returns - often less than inflation.

A share represents part ownership in a company that more than likely holds a large portion of it's net worth in real assets not cash, So this in itself offers some form of protection against inflation.

All things being equal, Inflation affects the buying power of cash. So the effect of inflation is higher prices. Which over time would see the prices the company charges for it's products as well as the $value of it's assets rise.

So over time inflation will be offset by higher dividends and higher share prices.

Same with property, you may look at an investment property returning 3.8% yield and think that this is only 0.8% return after inflation, but the fact is the property price and the annual rent both increase over time with inflation.

So if you are buying real assets inflation is far less important than if you are holding cash ( cash is trash )

 

[Tysonboss1]

In theory you are correct. If a company never pays dividend or return cash to shareholders than the value of the company is zero. Since what good is $100m cash sitting in the company if you were NEVER going to be able to get your hands on it?

Berkshire Hathaway is worth $120,000 / share and has never paid a dividend or returned a cent to investors.

The reason they are worth that much is because over 50 years warren has compounded the earnings rather than pay out dividends which has ment the asset base of the company has grown to over $200 Billion and the share price has gone from $12 to more than $120,000.

 

[awg]

A couple of points for the OP

* Value can be assessed by various methods

* Many investors prefer companies that pay no dividend because they believe the company will provide a greater rate of return than they themselves can attain..eg Berkshire

* Another type of company that virtually never pay dividends are emerging miners, you are paying for the commercialisation of the resource, then you might be able to sell the shares you bought for 35c for $3.50.

The potential value in these projects is assesed using models developed that are appropriate to the industry

 

[skc]

Berkshire Hathaway is worth $120,000 / share and has never paid a dividend or returned a cent to investors.

The reason they are worth that much is because over 50 years warren has compounded the earnings rather than pay out dividends which has ment the asset base of the company has grown to over $200 Billion and the share price has gone from $12 to more than $120,000.

I understand and Berkshire Hathaway is a great example.

What I said was theoretical...in theory, a stock that never (not 50 or 100 years, but never) pay a cent out to shareholders is worth nothing. You cannot value it any other way but zero.

 

[Sdajii]

I understand and Berkshire Hathaway is a great example.

What I said was theoretical...in theory, a stock that never (not 50 or 100 years, but never) pay a cent out to shareholders is worth nothing. You cannot value it any other way but zero.

Not exactly. Let's say Company XYZ was trading at $10 per share and had a book value of $100 per share, most of which was cash or very liquid assets. Immediately the share price would increase, or, someone with enough money would come along and buy the company, or, the shareholders would demand that the money was given to them. If the share price was too low compared to the real value of the company, it would force a situation where the shareholders directly got something out of it. The shareholders do own the company and can make any decision they want. Typically the shareholders don't kick up a massive fuss and unanimously demand particular action, because most of the time the directors are going at least a remotely decent job, so the shareholders sit back happy to leave things in capable hands.

The way I understand it, if every single shareholder (or close enough to all of them) wanted to liquidate the company and distribute the money obtained amongst themselves, it would have to happen.

Obviously, generally, things aren't so drastic (because share prices do stay higher than ridiculously low values because people understand the situation and buy them before they become so insanely undervalued), but you can see that there isn't a 'zero value' on shares in a company which never pays dividends as long as the company does have value.

 

[skc]

Not exactly...

The way I understand it, if every single shareholder (or close enough to all of them) wanted to liquidate the company and distribute the money obtained amongst themselves, it would have to happen.

Obviously, generally, things aren't so drastic (because share prices do stay higher than ridiculously low values because people understand the situation and buy them before they become so insanely undervalued), but you can see that there isn't a 'zero value' on shares in a company which never pays dividends as long as the company does have value.

No it is zero in theory if no money ever leaves a company. What you are describing there is money leaving the company via liquidation or return of capital.

Since what I describe is theoretical there isn't really much point talking about it much further. The reason that I brought it up was that it was actually a trick question in my uni finance tutorial many years back.

 

[Sdajii]

No it is zero in theory if no money ever leaves a company. What you are describing there is money leaving the company via liquidation or return of capital.

Since what I describe is theoretical there isn't really much point talking about it much further. The reason that I brought it up was that it was actually a trick question in my uni finance tutorial many years back.

Well then, what is your point? If I buy anything, whether it's a can of beans, a tonne of gold or a screwdriver set, if I don't sell it it has no value by that line of thinking. If I considered my tonne of gold or car or tools or anything else *of value* to have *zero value* I can guarantee someone would be willing to pay me more than I thought it was worth, given the chance, and that's how things' values are determined. You don't need to actually sell something to estimate their value or consider the value to exist, and shares are constantly being bought and sold anyway, so you have a constant valuation of them. The company exists, it has value, you can buy part of it, have true ownership of it, and have a say in how it is run proportional to how much of it you own. If the shareholders all demand it, the profits of the company go to the owners rather than being reinvested, but because most shareholders do understand the way it works they often want all and often most of the profits to be directly reinvested back into the property.

Things don't need to hand you cash to have value. Heck, even paintings or the chair I'm sitting on has a value, even if never sold.

In no sense do shares have no value, and if you see it that way you've made a pretty bizarre judgement.

 

[tothemax6]

Ah I see, it is because the company may release the equity back to the shareholders at some point.

Another type of company that virtually never pay dividends are emerging miners, you are paying for the commercialization of the resource, then you might be able to sell the shares you bought for 35c for $3.50.

Well again, that would only be if the company was at some point liquidated and returned the equity to the shareholders (i.e. when the exploration was finished and the land was handed over to a mining company etc). Otherwise, again we have the circular issue - the $3.50 is being produced by bidding the price up only.
I suppose my sticking point was the actual link between the equity and the share value. And it seems that since companies can/do return the equity to the shareholders at times, the price is actually linked to this future return.
Although mind you, I have seen some P/B ratios of 3+. Supposedly this is because the expected future equity is likely to be much larger, according to those buying.
Cheers

 

[robusta]

The value of a company is based on the value of the assets it owns and the earnings generated by these assets. A company does not have to pay a dividend to have a value, for example a company could not pay a dividend because it chooses to reinvest it's earnings back into opening more stores and generating further profits.

Picture this, You own shares in coca cola back in the 1900. they have one plant producing coke earning $50,000 / year. they can choose to pay out $50,000 per year in dividends or use the $50,000 per year to build a new plant every 3 years.

obviously the value of the coke company will sky rocket over time as they open more plants and don't pay dividends.

If they were opening a new plant every 3 years, then they would be earning about 33% on any money left in the business, compared to about 6% interest you would get in a bank account if they paid it out to you.

The above post is a perfect example of the compounding you can get within a company that has a high ROE and can retain those earnings and still earn a high ROE on those earnings.

This is how it would work with a company earning 20% ROE (return on equity) ,retaining all profits and assuming the market will only ever pay 10x earnings (PE 10)
Year 1
Equity $1.00 earnings $0.20 share price $2.00
Year 2
Equity $1.20 earnings $0.24 sp $2.40
Year 3
Equity $1.44 earnings $0.288 sp $2.88
Year 4
Equity $1.73 earnings $0.346 sp $3.46

Ah I see, it is because the company may release the equity back to the shareholders at some point.

Well again, that would only be if the company was at some point liquidated and returned the equity to the shareholders (i.e. when the exploration was finished and the land was handed over to a mining company etc). Otherwise, again we have the circular issue - the $3.50 is being produced by bidding the price up only.
I suppose my sticking point was the actual link between the equity and the share value. And it seems that since companies can/do return the equity to the shareholders at times, the price is actually linked to this future return.
Although mind you, I have seen some P/B ratios of 3+. Supposedly this is because the expected future equity is likely to be much larger, according to those buying.
Cheers

It is not so much the book value but the return you can get from that book value (ROE)

Let's look at two companies with a book value of $1.00, now if I told you one company was trading at book value ($1.00)and the other was trading at twice book value ($2.00) we would probably be more interested in the cheaper company.
Now if we dig a little deeper and find the first company is earning a ROE of 10% and the second is earning 30%, this changes the whole picture.
Company A ROE 10% EPS $0.10 SP $1.00 return to shareholder = 10%
Company B ROE 30% EPS $0.30 SP $2.00 return to shareholder = 15%

 

[Tysonboss1]

the $3.50 is being produced by bidding the price up only.

Yes, That is how the share price is decided. But obviously the more value inside the company the more people would be prepared to pay.

Price is what you pay, Value is what you get (in return for the price you pay).

I think when you purchase a share you should ask the same questions as you would when you are purchasing any other business. Most likely you would be comfortable paying an amount based on a certain multiple of it's earnings.

You would probably be comfortable paying a larger multiple for a business that is expanding and a much much smaller one for a company in decline.

There are many other factors as well, but it all comes back to what you are prepared to pay for the companies businesses, based on what they are doing now and what your opinion of their future is.

 

[Julia]

Tothemax: Do you feel any wiser as a result of this thread? Does it help you make decisions about what to buy/sell?

Have you considered that all the complicated considerations of what a company is worth may mean zilch if your capital doesn't grow?
Or at the very least if you don't receive dividends and franking credits which offset any fall in the SP?

Perhaps I over-simplify things, and I understand that the view is unacceptable to fundamentalists, but essentially buying shares in a company is the same as buying e.g. a house. It is only worth what someone is prepared to pay for it.

Take a look at QBE. It's endlessly touted as Australia's best managed insurance company. Financial advisers include it as an essential part of a core portfolio. But what has the SP done (i.e. your capital) in the last several years?
It has diminished in value. And the yield is hardly sufficient to make up for this.

Might be another way to approach your investing. You can spend days evaluating the intrinsic worth of a company, but if the market doesn't agree, you're simply not going to make money.

 

[skc]

Well then, what is your point?
In no sense do shares have no value, and if you see it that way you've made a pretty bizarre judgement.

Everything you say is true and valid and in practice can happen - I totally agree. What you fail to see is that my argument is a THEORY.

The reason that I brought it up, and the reason that it was a trick question in a finance tutorial, is that it helps you understand where does value of a share come from.

Here's the logic...
The value of the share comes from future returns.
Future returns consist of dividends, capital returns and capital gains.
Capital gains comes from people in the future placing a value on the returns further into the future.
Those returns further into the future consist of dividends, captial returns and capital gains.
And so on...

Take it to infinity, you are left with share value is nothing more than the present value sum of all future dividends and capital returns. Capital gain doesn't come into it because, at infinity, there is no more future returns. So the last capital gain term, at time = infinity, is zero. So in a situation, again in theory, where no money ever leaves the company (so dividend and capital returns = 0) the current value has to be zero.

A somewhat imperfect example - if I put a bar of gold into a safe, throw away the key and drop it into 5000m below the ocean (so that gold will see day light again), what is the value of such gold? Or how much will someone be willing to buy it off me?

If none of this makes sense to you that's fine... but it helped me understand the underlying components in share value at the time.

 

[Tysonboss1]

A somewhat imperfect example - if I put a bar of gold into a safe, throw away the key and drop it into 5000m below the ocean (so that gold will see day light again), what is the value of such gold? Or how much will someone be willing to buy it off me?

The Value of the gold Bar = Current gold price - cost of commercial dive contractor/submersable vehicle - cost of safe cracker - shipping fees - risk margin.

It's almost in the same league as an oil field trapped in 5000M, It would have value for those with the organisational skills to arrange for it's removal and explotation.

 

[skc]

The Value of the gold Bar = Current gold price - cost of commercial dive contractor/submersable vehicle - cost of safe cracker - shipping fees - risk margin.

It's almost in the same league as an oil field trapped in 5000M, It would have value for those with the organisational skills to arrange for it's removal and explotation.

This will be the last comment I make on this...

For the last time this is a theoretical situation, and the premise states that "IF no money ever leaves the company" (or IF the gold never sees daylight). Given that premise, I have showed how the value cannot be any other figure but zero. Because that is the maths of how share value is derived. It simply cannot be any other way. Period.

And I agree that you can do all sorts of things in practice to break that premise (e.g. shareholder forcing a return on capital, deepsea extraction the gold etc). But that's missing the point.

P.S. Just realise I had a typo in my post... I meant to say "So the gold bar will not see the daylight again". Sorry for the confusion.

 

[dhukka]

Perhaps I over-simplify things, and I understand that the view is unacceptable to fundamentalists, but essentially buying shares in a company is the same as buying e.g. a house. It is only worth what someone is prepared to pay for it.

Take a look at QBE. It's endlessly touted as Australia's best managed insurance company. Financial advisers include it as an essential part of a core portfolio. But what has the SP done (i.e. your capital) in the last several years?
It has diminished in value. And the yield is hardly sufficient to make up for this.

Might be another way to approach your investing. You can spend days evaluating the intrinsic worth of a company, but if the market doesn't agree, you're simply not going to make money.

Yep, it is definitely unacceptable to anyone practicing a form of value investing. Back in 2007, people were prepared to pay US$75 for a share in Lehman Brothers. Was Lehman Brothers worth $75 a share because that's what someone was willing to pay for it? Or was it worth something considerably less given it's leverage and exposure to toxic assets? Anyone remember what the price of Babcock and Brown stock was in early 2008? Was it really worth that much because someone paid that price?

How about ABC learning centres, does anyone remember that one? Go back to that thread and you will see people warning of how overvalued that stock was. How about the NASDAQ bubble? Stocks were doubling and tripling in a matter of days when they had no revenue and little assets. Were they worth those ridiculous prices because people paid them?

There is a confusion here between price and value, the two aren't the same thing.