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So a company decides to raise money by selling shares of its stock. The stock is offered at an initial price of their determination. The stock is then traded in a market where forces of supply and demand, as well as speculation, affect its price.

When a company performs well (or makes decisions that will likely increase the company's earnings in the future), more people want to buy that stock than do people wanting to sell it. This creates demand for that stock which causes its sell/bid prices rise. When a company performs poorly, the opposite occurs; more people want to sell the stock than want to buy. This creates a surplus that causes sell/bid prices to fall. Understanding this, people speculate over company performance to determine the future behavior of a stock, and attempt to "buy low, sell high" or "borrow high, return low" in order to make a profit.

But my question is regarding the first part of that process. What is it about company performance that causes the perceived value of its stock to rise? This is especially perplexing since I would guess that most people don't exercise their voting rights, and many stocks don't pay dividends. It's not like a shareholder has any direct financial gains from increased company earnings (speculative stock pricing notwithstanding). What is the intrinsic value of the stock?

It seems to me that all participants in a stock market tacitly agree that stock price will have a direct correlation with company performance. So another way of asking the question is, would an opposite agreement hold? What financially (this isn't a question about logistics, communication, or feasibility) stops all participants in a market from agreeing to value a particular company's stock inversely with respect to the company's performance?

Since I feel like I can't quite nail down my question, another form of it would be, why is stock market behavior driven by company performance?

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Great question. I've had the same doubts for a long time. –  user1175 Sep 16 '10 at 15:47
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3 Answers 3

up vote 21 down vote accepted

All stocks are held in the expectation that they will eventually return money to the shareholders, by one or more of the following mechanisms:

  • Paying dividends
  • Share buybacks, where the company buys out some of its own shares (in some ways this is quite similar to paying a dividend, but often has different tax implications)
  • A takeover by another company for cash (some takeovers are for shares, or a mixture, in which case the same question of valuing the new shares arises)
  • Liquidation, at which point the company's assets are sold and all cash is return to the shareholders

Just because they aren't paying anything out now, doesn't mean they won't in the future. The market value fluctuates based on the expectations of the people buying and selling of what those future payouts will be.

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Holy crap that was exactly the answer I was looking for!! I don't know why this basic consideration isn't explained in all stock trading introductions. Thank you! –  G-Wiz Apr 11 '10 at 21:54
    
Btw when you say "taken over for cash" do you mean through the company buying back the shares? –  G-Wiz Apr 11 '10 at 21:57
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I think by using the specific words "taken over" that Ganesh is referring to a corporate takeover, which is when another company likes the one you're holding so much that it wants to own all of it, and makes a successful offer to buy all outstanding shares at a price significantly higher than the market price. –  Chris W. Rea Apr 12 '10 at 0:09
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I've now edited the answer to add buybacks and another mechanism I remembered - liquidation. –  Ganesh Sittampalam Apr 12 '10 at 14:47
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Actually cash generating companies tend to come under a lot of pressure to pay dividends, though I'd have to hunt for a while to find specific examples. Remember that the main investors in most or all listed companies are mutual funds and pension funds - and many of them certainly do take an interest in how companies are run and place direct pressure on the directors. –  Ganesh Sittampalam Sep 21 '10 at 20:09
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The intrinsic value of a company is based on their profits year on year along with their expect future growth. A company may be posting losses, but if the market determines there's any chance they will turn a profit one day, or be a takeover target, it assigns value to those shares. In normal times, you'll observe a certain P/E range. Price to earning ratio is a simple way to say the I will pay X$ for a dollar's worth of earnings. A company that's in a flat market and not growing may command a P/E of only 10. Another company that's expanding their products and increasing market share may see a 20 P/E. Both P/Es are right for the type of company involved.

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If a company is doing well, it seems less likely to go bankrupt. If a company is doing poorly, it seems more likely to go bankrupt. The problem is, where is the inflection point between "well" and "poorly"? When does a company start to head into oblivion? Sometimes it is hard to know. But if you don't call that right and hold onto your shares when a company is tanking, others, who call it before you do, will sell off, devalue the share price, and now you've missed your chance to get out at a good profit. If you hang on too long, the company may just go bankrupt and you've lost your investment entirely.

A healthy profitability of the company therefore has to bolster investor confidence in avoiding this very unpleasant scenario. Therefore, the more profitable a company is, the more shareholder confidence it inspires, and the more willing to pay for it in the form of increased share price.

And, this then has a "meta" effect, in that each shareholder thinks, "all other investors think this way, too," and so each feels good about holding the stock, since he knows he can likely easily liquidate it for good cash if he needs to, either now or in the next year or sometime hence.

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