Why Is it in Investors Interest To Hold Equities

Discussion in 'Economics' started by tommo, Oct 23, 2007.

  1. tommo



    Firstly please excuse this very basic economic/investing question.

    It is my understanding that aside from speculation (purely gambling on the future price of a product) the markets serve a more fundamental purpose particularly in the sense of giving investors a yield. For example money will flow across the FX market to make the most of attractive yields in interest rates hence carry trades Money will flow into bonds because of attractive yields and a safe haven for investors. In both these occasions price speculation itself isnt the key factor, if i know that i can get 5% extra interest on currency x then im not going to worry about where it is trading im just going to transfer my money (hope my assumptions are correct so far).

    SO in summary price moves in bonds and currencies are very often reflected by yield gained for having your money in that financial vehicle.
    However, what links a shares price to company performance? Who says share prices should go up as the economy grows? Yes i know the company will be doing better (all things being equal) and in theory the company's value deserves to be higher. But the world of finance isnt about who deserves what, i want to know what makes it in investors interests to invest in equities when very few of them pay a dividend, or yield?
    If the answer is, they invest in equities because everyone assumes as the economy grows the shares go up that seems more of a self fullfilling prophecy than any economic reason?

    Hope this makes sense, thanks you
  2. I do not know of any fixed link. Price of anything may change at any time for reasons that are unknown to me.
  3. I like what Jack Welch said. "Share price is a by-product of a company".
  4. Daal


    say a company is making $1 billion a year but its trading a $10 million of value. just the prospect of a takeover or the fact that the company can at anytime announce a gigantic dividend(after all the CEO probably owns stock and options and has interest on seeing the price go up) will make the stock go up to around what the market is valuing the avarege company at that time. if it dips too much below people will buy in antecipation of events like that
  5. Let me give you an analogy that is actually quite similar to the case of owning equity.

    Imagine somebody you know comes to you telling you that they are going to start a business, but they need capital to start it. They tell you that the business has the potential to make 15% a year and you will get a 15% return on any money you invest. Your next best alternative to invest in will give you 8%, but it is less risky. You have the potential to lose a 10% in the first investment, but the most you will lose is 3% in the second investment. Since the first investment is much more risky, you require a greater return. In this case, let's say you decide the risk to reward is worth it.

    The same concept applies to owning equity. You literally own a stake in the company. The price of the stock is related to the risk and the potential growth in profits of the company over a defined period. Let's say you buy a high-flyer. The company is growing 20% a year. The value of the stock *should* grow at a similar rate to offset the risk. The shareholders will only be willing to sell the stock at a price that they deem fair based upon the growth and risk of the company.

    On the same token, the directors of the company will also factor in the risk to reward in making financial decisions. They recognize that shareholders expect a premium on their stock. If it is a high-flyer, the directors of the company may be willing to take more risks to satisfy the requirement of the shareholders through large potential profits.

    On the other hand, if you are a manager of a company whose stock barely moves but instead pays high dividends, then the shareholders of this company *expect* the dividend to be paid. As a result, the directors will be more risk averse and will only take on projects that can satisfy the smaller required return by shareholders.

    So, you see, shareholders influence the financial decisions of the company. The shareholders place a value on the "ownership" of the growth of the company. They expect a capital gain on the shareprice relative to the risk premium of the stock.

    Hope this helps!
  6. In response to the thread question.

    To make more money by milking those winners as much as you can by riding the trend for the longest time possible.

    My research and testing has showed that the big winners are those that were held for the longest amount of time.

    Of course if its a dog you shouldn't waste any time in letting them go and finding the next one.
  7. bluud


    Can someone tell me if all the assets of a company were worth $1 million ... and the total number of shares available for the full amount of the company were 100,000 ... (each share being $10) ... and regardless of the revenue, the company (always and for sure) returned 10% net on the $1million dollars each year ... that is $100,000 ... at what price range would the companies shares trade the second year? ... how about the third year?


    Now if we take away the companies assets and say the company leases everything ... but total revenue is $1 million ... net income is $100,000 ... what price range should the company stocks trade at?
  8. bluud



  9. What you have presented represents a "market capitalization" at parity with the company's book value. Very few stocks have a 1 to 1 price/book value. The multiples of the price to book are used to determine "which" stock is "better" valued than another using fundamental analysis. If you pay off all the bills, sell everything, the amount you're left with is book value.

    By mixing your examples by adding $100K in earnings, the book value increased by 10% in your above example with earnings of $100K. So, will the price go up 10%? Possibly, possibly not, because we don't know how that company equates to others in it's sector and the overall market.

    The S&P 500 has an average Price to Book ratio of approximately 3 to 1. Meaning that your example would have the stock price at one-third of the overall market.

    Now for your second example, I would assume you mean that the Company has $100K in the bank from earnings, and the same number of shares out, same valuations apply and if it was one to one price to book, it would be priced at $1.00

    Earnings, dividends, future expectations ( a big one, as with the dot.com days and China, LOL) all affect the pricing.

    Remember, after all is said and done, all the analysis is over with, this is a supply and demand open market system. A stock is "worth" only what someone is willing to pay for it.

    There is no way to pre-determine supply and demand.


  10. StavrosW


    wow. I thought this was a forum for people to post trade strategies and ideas. I didn't realize it was a basic investing 101 forum.
    #10     Oct 24, 2007