Why are stock prices related to company performance?

Like electricity or semiconductors, the stock market remains a mysterious invention of the modern world, something that few of us understand entirely even though we depend upon it everyday.

I hadn't given the stock market much thought myself until I watched Niall Ferguson's excellent documentary The Ascent of Money (available to watch free online here), which shows how some of the most pivotal moments in history (the victory of the North in the Civil War, the coups of Latin America, the defeat of Napoleon) had important financial backstories to them.

This sparked my curiosity to really get a grasp of what the stock market is about. Not just that layman's wisdom of "buy low, sell high," but to really understand why the stock market exists, the value that it contributes to society, and the fundamental forces that drive stock market prices (the first and second points have gotten rather lost lately, so much so that Robert Shiller has had to write a book defending the idea that finance is useful and good).

I found the answer to most of my questions in this really good guide by HowStuffWorks.com, which walks the reader through IPOs, stock exchanges, incorporation, brokers, and the like.

But there was one question I had that I couldn't seem to find an answer for anywhere: why does the stock price have anything to do with company performance?

Often the lay explanation of how the stock market works is trapped in a circular logic. You buy stock, the thinking goes, to sell it to someone else for a higher price. But then that person, thinking the same thing, wants to sell it to someone else for an even higher price. Neither person in this scenario is thinking of profiting from the company per se. But surely it can't be that the only value of a stock is to unload it onto someone else later. So is there any value in holding on to the stock? Does the stock have any value on its own, even when most modern companies do not return profits to its shareholders?

The answer is, of course, yes. I owe (what I think to be) my understanding of the answer to the discussion at this forum, whose contributors seem to be pretty well informed. I haven't seen any discussion of this question hardly anywhere, let alone an answer, so I'm sharing it here, in case others are also curious.

But before we begin this explanation, it's worth taking a step back and establishing the mechanics of the simplist kind of stock, dividend-paying stocks. This detour will be useful to those with less background in the stock market, and will help me cement my new-found knowledge. If you already know this stuff, you can skip down to the next section.

Beginner's Detour

Although the modern stock market is incredibly complex, the earliest system of stocks was rather straightforward. The stock market was invented for two reasons: to raise money for the company, and to spread risk. The Dutch East India Company, widely regarded as the first company to issue public stock, was in great need of both of these benefits. Its voyages to the Orient were not only very expensive, but also very risky and dangerous. Without the stock market, the company would have to borrow at interest, which would have been a bad move given that the outcome of its expeditions was so uncertain. Stocks offered an ingenious way around this problem by spreading risk (and reward) amongs many, many private owners. And people gladly offered up their money, anticipating the massive profits that the company would soon earn.

In the Dutch East India Company, shares entitled their holder to two rights—a portion of the annual profits, and the right to cast a vote in company decisions. Modern stocks are much more complex (by, among other things, dividing stocks into different "classes," which entitle their owners to varying degrees of benefits). But even still, these two rights are the principal benefits that shareholders can expect. 

When shareholders receieve a portion of the profits (called dividends), as in the case of the Dutch East India Company, it is clear why trading is based on company performance. The more profits the company reaps, the larger the dividends will be, and the return will be.

Some people who did not get a chance to buy a stock in the company when they were first being sold wanted to get into the action later; and others who bought the stock wanted to get rid of it. Thus a stock market was born. Note that none of the money trading hands in the stock market went to the Company. It was strictly private agreements who were trading commodities, like people buying baseball cards from each other.

Valuing the stock is a subjective calculation. The stock yields a stream of annual dividends, of an uncertain amount, for the lifetime of the company. As long as the present value of the stream of money is more than purchase price, then it's a good investment.

The idea of present value is of central importance to valuing stocks; stocks, like all investments, return money in the future, money in the future is worth less than money in the present.

This is because of interest rates. Suppose someone offers you $100 today or $100 next year. Suppose also that the generally prevailing interest rate is 5% (say in a savings account, or buying government bonds). Then if you take the $100 today and put it in the savings account you'll have $105 next year. So because you lose that year of not collecting interest, $100 in the future is worth less than $100 today. The present value of a future sum of money is the amount you would need to invest today to collect that sum of money at the future time. To collect $100 next year, one would need to invest $100 / 1.05 = $95.24 today. This is the present value of that money.

Here's a numerical example to show how this works with the Dutch East India Company. Suppose you buy the stock for $30. Suppose the interest rate is 2% and suppose that these are your annual returns for the stock.

Year 1: $20                            Present Value: $19.60
Year 2: $15                            Present Value: $14.42
Year 3: $25                            Present Value: $18.85

Total Present Value over 3 years: $52.87

So the stock pays for itself, even though each year the return is less than the purchase price of the stock.

However, just knowing that you get a return on the stock is not enough. The question you should ask on an investment is not whether you'll get a return at all, but whether you'll get more return here than you would collecting interest on safe investments (i.e. U.S. government bonds, the standard that modern markets use). It only makes sense to take on the additional risk of buying stock if there is potential for making more money. This is why interest rates are so important.

This Dutch East India type stock—the kind that returns dividends—is the simplest kind of stock. But even if we have just a couple dozen companies with this kind of stock, we already have a pretty robust stock market. Some stocks may give small but steady returns; others may be more volatile; a start-up may just be taking off that in the future will return vast sums of money; and the uncertainty around predicting how companies will do at the end of the year will lead to tons of buying and selling. When there are more buyers than sellers of a particular stock, that stock price goes up. When there are more sellers than buyers, the stock price goes down.

Non-dividend paying bonds

Most public companies, as I noted earlier, don't pay dividends to their shareholders. So why do shareholders care about company performance?

The crucial point is that all companies will eventually pay dividends. Paying dividends is the default option. The reason that companies don't pay dividends is because they believe they can generate a larger return for their shareholders by expanding the company than the shareholders could if they took their dividend and invested it themselves. But no company can grow forever (at the very least, scale problems will get in the way). As the company starts to reach its growth limit, it will run out of profitable uses of the money. At this point, the profits will come back to the shareholders, and when this moment comes the profits will be enormous (relative to the company's starting point).

This kind of stock, you'll notice, is different. When you buy this stock, you don't get anything in the short run. But eventually, say after 10 years, when this company does start issuing dividends, it's dividends will be gigantic. So even though you don't get anything for a while, it's worth buying. In the meantime, people buy and sell depending on how much they think the company will eventually be worth.

It's not an automatic process by which the company starts to issue dividends. The company may resist returning profits to its shareholders (e.g. see Apple). But once the shareholders feel that the company doesn't need the money for investment, or can't invest it better than the going interest rates, then they'll start calling for dividends, and vote for such measures at shareholder meetings.

Even if stocks never paid dividends, they would still have some value, because of a stock's ownership power. If someone amasses a controlling stake in a company (usually 51% of stocks), then they can decide how the company will be run. This power, in turn, allows someone to make a lot of money. Take an extreme example: suppose you have a company with $1 billion worth of assets, and 3 stocks, each trading at $1 each. I buy two of the stocks for $2. Then I can go and sell off the company's assets—their buildings and machines and land and other property—and pocket all the cash. This way of making money is called "corporate raiding," and is generally frowned upon. But it's another way the performance of the firm is reflected in its share price.

What I have described is the underlying fundamental forces that move the stock market. Everything else is just people trying to game the system. The layman's understanding of the stock market is based on this gaming of the system—taking advantage of people's expectations, betting on what other people think will happen, or even betting on what other people think other people will think will happen.

But this isn't what the stock market is about. The stock market is about financing companies that will be profitable, and wanting to partake in company profits and ownership. Everything else is, I think, secondary.