The Stock Market – What’s it for?

The forward moving time machine is a complicated one. Other than private equity, the stock market is the most complicated.

Vocabulary

Private equity – Ownership in a business, or other investment where there is no public market if you want to sell your position.

The stock market – What’s it for?

The stock market is a way for individuals to participate in the growth and income of a business that is too large for anyone to own by themselves. The corporation divides up its worth into units called shares and allows other people to participate in the business.

Vocabulary

Corporation – An entity that has separate legal status. A shareholder’s potential loss is “limited” to the amount of their investment. You will see the word limited in some corporate names or LLC. LLC means limited liability corporation.

The corporation can issue new shares and get the money for itself for growth or debt reduction. More commonly people buy shares offered for sale on the stock market by other people. A secondary market.

The stock market provides several values to investors and businesses.

  1. It allows a business to get money to grow and operate effectively.
  2. It provides people with a way to buy or sell shares whenever they want to do so.
  3. It provides rules and regulation that require business to publish information, like financial statements, that allow investors to be able to make judgements about the value of a particular business.
Buying Microsoft.

If I buy stock, call it 100 shares of Microsoft, what have I done?

To say I bought 100 shares tells too little. A share of a company is a certificate that represents ownership in the business. When I buy stock I buy a business. If you think about buying stock instead of buying a business you will eventually make an easily avoided mistake.

You can value a business. You cannot value a stock without understanding the business. You should buy or sell based on your valuation.

Owning 100 shares of Microsoft will not let me influence the company. The company is worth more than $1.1 trillion and I spent $15,000 for my position. I have a tiny piece of the company, but I will do as well as the company does. I bought a business and I should decide to buy based on business ideas not on a good story from a newspaper or a TV guru.

Think about what the business does

Businesses, like people, must earn their money. They do it the same way. They trade their services or products for the customer’s money. After all the expenses are paid. and after income taxes, provision for future growth, capital expenditures, and debt reduction are made, there is something left over to distribute to the shareholders. A dividend.

It is a common form of valuation to assess value as the net present value of future dividends.

Vocabulary

Dividend – An allocation of corporate business income to an owner.

Net present value – The value today of an expected stream of future payments adjusted for the yield required. For example, in a world where yield must be 10%, $100 to be received a year from now has a present value of $90.91. $90.91 invested for one year at 10% will become $100.00. You can use a formula or a spreadsheet to do the calculation when there are many payments to come at different times in the future.

Microsoft dividend

Microsoft pays $0.51 per share per quarter as a dividend. So for your 100 shares you get $51 four times a year. That may seem like too little and dividends are a key factor in deciding how much a company is worth. You need to look deeper to assess value. Fifteen years ago Microsoft paid $.08 per quarter. Thirty-two cents per year. but the stock price was about $27.00 so the payment each year then was 1.15%. Today it is 1.34%.

If you bought 100 shares in early 2005 you would get 1.15% yield in cash and the prospect of growth. The growth prospect has driven price of the stock up and now you get $2.04 per share in cash, 7.6% on cost. Plus a profit of $12,300 should you decide the growth opportunity is not there and the dividend is too low.

Estimating the value of future dividends

Competion

Microsoft is a gigantic business with huge cash reserves, talented management, and many product lines in many markets. It is dominant in its industry. We can expect it will be able to compete successfully with any who try to establish themselves there. So competition may not be too harmful. They must be aware but not paranoid.

We can expect they will not be right all the time. I owned a Zune. They have been less than successful with their browser, their phone and their search engine. If they are not making some mistakes they are not trying hard enough. Just like you and I. Do not let the odd controlled failure influence you.

Government action

Governments are notoriously driven by large success. They believe it restrains trade and should not be permitted. The government might try to break up a giant business or restrict its activities.

Neither benefits the consumer. Nonetheless they might try. Maybe succeed. Should you worry? Probably not, you would just have shares in several businesses. Should you worry about competition taking over. Maybe but when the government brought antitrust action decades ago, Microsoft’s competitors were more concerned about 4 or 5 agile and aggressive mini-Microsofts in their market. Behemoths are often slow to act and less formidable competition.

Management skill

The purpose of executive management is to allocate resources effectively. Other management runs the operation efficiently. If the capital allocation crowd do a poor job no amount of efficiency will fix the problem. Pay attention to executive decisions and notice if customer service or product development is falling off. Sometimes the executive level doesn’t set a demand for excellence into their corporate culture. Bad mistake, and one you can see if you use their products.

Change in the discount rate.

Maybe some day the yield you require will be 20% instead of 10%. Inflation might do that.

It could happen yet it might not affect you. If you owned dollar denominated asets like term deposits or bonds, the money is exposed to inflation and that makes its purchasing power less. Business though are less affected. They adjust their prices as their costs rise and their return as a percentage may change little. An investor might want to know they have that pricing power without affecting the number of units they sell.

Every investor in the stock market must know two things

1)There are always two values for a business.

  1. The intrinsic value being the value of the money it will earn in the future,
  2. The market price, essentially what a share will fetch if offered for sale.

Intrinsic value is what the calculation of value of future dividends comes to.

The market price is affected by many things. Not the least is ability of humans to listen to stories without checking the facts. You may buy the stock looking for dividends over the years. I might buy it to flip for a profit next Tuesday. Someone else may be selling to raise money for their divorce lawyer or to settle an estate. Intrinsic value will affect market price but the market price will be quite volatile around that value.

2)Risk means something unusual

Most people see risk as the possibility of loss. While there is such a possibility in any business, that business risk is more manageable than the market price risk. Think about it this way. If Microsoft stock price falls from $150.00 to $100.00 would that have any affect on what they do, what they earn, or what their customers see? Not likely.

Eventually the market price will reflect the intrinsic value, so your only risk in this area is timing. You might need the money back when the price is low. Risk of loss in the stock market is a two variable risk. The price is low AND you need the money.

If the intrinsic value calculation is well done, and you don’t need the money, then the market price is not relevant. It may represent a buying opportunity even.

You will invest better if you don’t pay much attention ot the market price and the resulting statistics that come from it. As Warren Buffett has said, “We buy businesses or parts of them. When we buy stock, we don’t care if they close the stock market for 10 years.”

Patience and discipline are important.

Tomorrow we will look at ways to invest. Products that add advantages or overcome weaknesses in your approach.


I help people understand and manage risk and other financial issues. To help them achieve and exceed their goals, I use tax efficiencies and design advantages. The result: more security, more efficient income, larger and more liquid estates.

Please be in touch if I can help you. don@moneyfyi.com 705-927-4770

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