What is a stock? A stock is a small stake in a company. But what does that really mean?
First Principles Thinking
Elon Musk recently popularised the term first principle thinking which in layman’s terms refers to questioning assumptions until you get down to the bare bones of the matter.
This can apply to defining a stock too. A stock represents part-ownership of a company. But what does being a part-owner of a company mean? Let’s dig deeper.
As a part-owner of a company, you are entitled to receive dividends from the company. The company can choose to pay dividends to shareholders when there is excess cash on the balance sheet. As such, we can say that if you own a stock, you are entitled to a stream of future cash based on the profitability of the company.
This is one of the main reasons investors buy stock in a company. But that’s not all. In a well-oiled stock market, investors can buy and sell stocks to each other.
As such, not only are stockholders entitled to future dividends, but they can also sell the stock – or in other words, this “entitlement to future cash” – to other investors in the stock market.
So why do stock prices fluctuate so wildly?
Once we understand what a stock really is, we realise that the value of a stock should be tied to cash that the stock owner can get.
In theory, the value of a stock is all of the stock owner’s future cash flows discounted to the present day. But if stocks have a very easily defined value, which in theory, should not fluctuate on a day-to-day basis, why do stock prices still gyrate wildly?
There are many reasons for this. First, the cash flows of a company may be hard to predict and may depend on many factors. When situations change, the company’s cash flow outlook can change too, which means the present value of the company’s stock can fluctuate.
Also, investors may make different assumptions about a company which also causes market participants to value a company differently. All of which can lead to fluctuations in the stock price as investors are willing to pay different amounts for a stock.
The discount rate that is applied to value a company is also highly dependent on numerous factors such as the inherent risk in the business and the risk-free rate which is set by central banks. Investors may apply different discount rates to future cash flows based on how they perceive the risks to that cash flow materialising.
The discount rate is also affected by the risk-free rate. Usually, central bankers will meet a few times a year to decide on what the risk-free rate will be. When the rate changes, the value of a stock should change too.
There are also investors in the stock market who simply don’t care about value. All they care about is being able to sell a stock at a higher price to someone else.
These traders simply buy and sell a stock in the hopes that the stock price goes in the “correct” direction for them to make a profit.
Even if a stock seems very overvalued compared to the potential future cash flows of the business, these traders are still willing to buy the stock in anticipation that someone else will buy it from them at an even higher price.
The gravitational pull of value
While stock prices can fluctuate wildly, over time they tend to gravitate toward the intrinsic value of a company.
Benjamin Graham, mentor to Warren Buffett and the author of classic investing texts such as The Intelligent Investor, once said that in the short run, the stock market is like a voting machine but in the long run it is like a weighing machine.
This makes sense as eventually, a stock should trade close to the present value of its future cash flows. For instance, if a stock is too cheap, investors can simply buy the stock at a discount and make an outsized profit from the actual cash flows paid to shareholders.
This basic principle should be music to the ears of long-term investors, especially in today’s bear market. Although it may feel unpleasant when your stock price falls, it is important to take a step back and realise the true meaning of being a shareholder.
When you do so, you can properly assess the actual value of your stock.
Note: An earlier version of this article was published at The Good Investors, a personal blog run by our friends.
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Disclosure: Jeremy Chia does not own shares in any of the companies mentioned.
