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This is a question that has bothered me for awhile about the fundmental nature of the stock market as a whole, and no one has given a satisfying explanation. What is root cause of a stock having value to purchasers if the stock doesn't pay dividends?

The obvious answer is that they can re-sell it to the someone and make a profit. However, that leads to the question as to why the next person feels it has value, other then to sell it to a third person etc etc. At some point some other source of income has to come from the constant selling/buying of the stock or else this is nothing more then a collectables bubble making Ameritrade rich on commisions. There must be some other intrinsic value to owning non-dividen stocks, but I'm not sure I fully understand the market forces involved.

To put things in an absurdly nerdy manner I feel as if I'm missing the base case in my inductive reasoning. If I'm trying to prove that person P should expect to profit from purchasing stock my inductive reasoning, projected backwards in time, would look like:

   Prove:  buyStock(p) = buyStock(P+1) + $ (my potential profits are > profit seller expects)

   because:
   Inductive: buyStock(P-1) = buyStock(P) + $ (someone in future will buy from me for a profit)
   base case: buyStock(0) = $$$ (person 0 profits ....somehow?)

In cases where companies pay dividens the base case is easy, person 0 gets a dividen as profit, proof done QED. But what about cases where a company is not currently paying dividens and is unlikely to do so?

I know that the stock price will go up as the company performs better, but I don't know why that is true either! If I own only 1% of the company I have no way of accessing the companies money, goods, or other resources. Rather the company is near bancruptcy or has trillions in their coffers does me no good because I can't access it in any way! I don't fully understand what market forces should cause my slip of paper to be worth more if the company I have no say, controll, or access to happens to do better. I'm sure if I knew my 'base case' I would be able to fully explain the correlation between company profit and stock price, and vic-versa, but simply knowing people will pay more for stock from a better performing company doesn't explain the intrinsic value.

So far I have two potential explanations to explaining my 'base case' as to the root advantage of trading stocks, but I don't feel either fully explains the advantage. The first is that companies often do stock buy-backs. This is definitely a source of profit for amateur traders, but I don't think this answers the question so much as makes it more indirect. The reason the company buys back it's stock is to 1) increase stock price and 2) have stock to sell back later. The company is not gaining immediate profit (I think) from the buyback, so they are not my base case in my inductive reasoning. The only reason the company seems to care about stock price is to resell later. In effect I could envision the company doing the buy-back as just another trader buying and selling stock (person p-1).

The other explanation, and so far the only one I like, is the risk of hostile take over. As long as there is a chance for someone to, one day, purchase 51% of the stock and now own the company this gives the stock value. Even if there is no reason for me to expect someone to try a hostile take over now, or close to now, there is still a chance that at some point eventually someone will be interested in doing so, and so everyone is really buying stock in the hopes of eventually selling it to someone who values it not for resell, but for a hostile takeover.

I like the above explanation, but it still fails to cover one use case. What about companies that only place 49% of their stock out there, while maintaining 51% for themselves. If these companies also refuse to pay dividends is there any incentive at all for anyone to buy this stock? how is the stock anything more then a sheet of paper?

So...can anyone explain market forces I'm missing? are there other advantages to holding of stock, or other means of making a profit from stocks, that make them ultimately worse constant trading? what forces stock price to have a correlation to company success rate?

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marked as duplicate by Dheer, JoeTaxpayer Jun 26 at 2:11

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IPOs will often be a relatively small amount of the overall stock of the company and it may be worth studying that as that is your base case to understand. –  JB King May 8 at 20:19
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This ground has been covered here before. See money.stackexchange.com/questions/17186/… and money.stackexchange.com/questions/1385/… and money.stackexchange.com/questions/24318/…, to start with. –  Chris W. Rea May 9 at 4:49
    
A company has a value. If you shut a company you own down, all that is left once the company is liquidated, will be your income. And stocks mean (partial) ownership of a company. –  Alexander May 9 at 12:55
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I feel the same way: the shares of stock you own have no intrinsic value except in the minute voting power that you have -- with which, if you gathered enough support, you could in theory elect to liquidate the company's assets and pay the proceeds to the shareholders (and bondholders). Since that is unlikely to occur, the only value you can ever be certain to receive out of your investment is whatever you can some day convince another person to pay you for it, which sounds very similar to a pyramid scheme to me. But the same applies to Bitcoin or dollars. It all operates on faith. –  dg99 May 9 at 22:17
    
@Alexander: While it is true that shareholders (i.e., those with an equity stake) will receive some of the proceeds of liquidation of company assets, shareholders receive what's left after creditors and employees (in that order) receive what they're owed. See en.wikipedia.org/wiki/Liquidation#Priority_of_claims –  Jubbles Jul 9 at 2:47
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9 Answers 9

up vote 7 down vote accepted

Dividends are not fixed. A profitable company which is rapidly expanding, and thus cash-strapped may very well skip dividends, yet that same fast growth makes it valuable. When markets saturate, and expansion stops, the same company may now have a large free cash flow so it can pay dividends.

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A share of stock is a share of the underlying business. If one believes the underlying business will grow in value, then one would expect the stock price to increase commensurately. Participants in the stock market, in theory, assign value based on some combination of factors like capital assets, cash on hand, revenue, cash flow, profits, dividends paid, and a bunch of other things, including "intangibles" like customer loyalty. A dividend stream may be more important to one investor than another. But, essentially, non-dividend paying companies (and, thus, their shares) are expected by their owners to become more valuable over time, at which point they may be sold for a profit.

EDIT TO ADD:

Let's take an extremely simple example of company valuation: book value, or the sum of assets (capital, cash, etc) and liabilities (debt, etc). Suppose our company has a book value of $1M today, and has 1 million shares outstanding, and so each share is priced at $1. Now, suppose the company, over the next year, puts another $1M in the bank through its profitable operation. Now, the book value is $2/share. Suppose further that the stock price did not go up, so the market capitalization is still $1M, but the underlying asset is worth $2M. Some extremely rational market participant should then immediately use his $1M to buy up all the shares of the company for $1M and sell the underlying assets for their $2M value, for an instant profit of 100%. But this rarely happens, because the existing shareholders are also rational, can read the balance sheet, and refuse to sell their shares unless they get something a lot closer to $2--likely even more if they expect the company to keep getting bigger.

In reality, the valuation of shares is obviously much more complicated, but this is the essence of it. This is how one makes money from growth (as opposed to income) stocks. You are correct that you get no income stream while you hold the asset. But you do get money from selling, eventually.

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I dont think this answers my question. I know the owner of stock is hoping to resell for more, I just don't know what intrensic value cause the stock to have increased resell value. owning 1% of a company doesn't let me acccess the capital, cash, revenue, or any of the other intangibles. I can't withdraw, use, or exploit any of that unless I own 51% of the company. So why do I care that the company has more of them? It feels like your answer still goes back to "someone will buy for more later" without explaining why this price esculation should continue to occure. –  dsollen May 8 at 21:43
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@dsollen - Price goes up if the underlying asset (the business) becomes more valuable. This is not necessarily the same as the Greater Fool Theory of asset appreciation. You seem to think that there's no reason one person will pay more later except blind luck or something. A person will pay more later if the business is intrinsically bigger at a later date. If the share price didn't go up, but the company got very large--if, e.g., it had a pile of cash exceeding the market cap--the company or someone else would bid up the price until it was more in line with the underlying value. –  Rick Goldstein May 8 at 21:57
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what I'm saying is that there must be some way to exchange the stock for access to the companies wealth for company success to increase intrinsic stock value. If I can go to the company and say "I own 1% of the company, I want to cash out here's all my stock give me 1% of your net worth in cash" then the corrolation between company success and stock value is clear. However, I can't do that. So what method do I, or anyone, have, now or in the future, to draw some sort of profit out of the company or the companies assets directly, not from other stock traders. How does one cash in stocks? –  dsollen May 8 at 22:26
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@dsollen - Money is fungible. What difference does it make if you withdraw money from the company bank account, or sell your shares in the market? Hopefully, my expansion of my answer makes it more clear why the share price actually does (to an extent, at least) reflect the value of the business assets and operations. –  Rick Goldstein May 8 at 22:49
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@dsollen - no not all investor and traders buy in the hope that one day the company will pay dividends. Most buy because the company is performing well and they think it is a good company to invest in whilst it keeps performing well in order to eventually make a capital gain. And yes in some cases you may make a capital loss - that is why it is more risky to invest in the share market than putting your money in the bank. The returns from capital gains are more than the returns from dividends. Many companies paying very high dividends can perform very badly, so many people don't invest in them. –  Victor May 9 at 21:37
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One way to value companies is to use a Dividend discount model. In substance, it consists in estimating future dividends and calculating their present value. So it is a methodology which considers that an equity is similar to a bond and estimates its current value based on future cash flows.

A company may not be paying dividends now, but because its future earnings prospects are good may pay some in the future. In that case the DDM model will give a non-zero value to that stock.

If on the other hand you think a company won't ever make any profits and therefore never pay any dividends, then it's probably worth 0!


Take Microsoft as an example - it currently pays ~3% dividend per annum. The stock has been listed since 1986 and yet it did not pay any dividends until 2003. But the stock has been rising regularly since the beginning because people had "priced in" the fact that there was a high chance that the company would become very profitable - which proved true in the long term (+60,000% including dividends since the IPO!).

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Also note that a share of voting stock is a vote at the stockholder's meeting, whether it's dividend or non-dividend. That has value to the company and major stockholders in terms of protecting their own interests, and has value to anyone considering a takeover of the company or who otherwise wants to drive the company's policy.

Similarly, if the company is bought out, the share will generally be replaced by shares in whatever the new owning company is.

So it really does represent "a slice of the company" in several vary practical ways, and thus has fairly well-defined intrinsic value linked to the company's perceived value. If its price drops too low the company becomes more vulnerable to hostile takeover, which means the company itself will often be motivated to buy back shares to protect itself from that threat.

One of the questions always asked when making an investment is whether you're looking for growth (are you hoping its intrinsic value will increase) or income (are you hoping it will pay you a premium for owning it). Non-dividend stocks are a pure growth bet. Dividend-paying stocks are typically a mixture of growth and income, at various trade-off points. What's right for you depends on your goals, timeframe, risk tolerance, and what else is already in your portfolio.

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Instead of giving part of their profits back as dividends, management puts it back into the company so the company can grow and produce higher profits. When these companies do well, there is high demand for them as in the long term higher profits equates to a higher share price.

So if a company invests in itself to grow its profits higher and higher, one of the main reasons investors will buy the shares, is in the expectation of future capital gains.

In fact just because a company pays a dividend, would you still buy it if the share price kept decreasing year after year?

Lets put it this way:

Company A makes record profits year after year, continually keeps beating market expectations, its share price keeps going up, but it pays no dividend instead reinvests its profits to continually grow the business.

Company B pays a dividend instead of reinvesting to grow the business, it has been surprising the market on the downside for a few years now, it has had some profit warnings lately and its share price has consistently been dropping for over a year.

Which company would you be interested in buying out of the two? I know I would be interested in buying Company A, and I would definitely stay away from Company B. Company A may or may not pay dividends in the future, but if Company B continues on this path it will soon run out of money to pay dividends.

Most market gains are made through capital gains rather than dividends, and most people invest in the hope the shares they buy go up in price over time. Dividends can be one attractant to investors but they are not the only one.

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But what difference does it make how much money company A makes, if they never give any of it to you? So you own a share in a very profitable company. But if there are no dividends, you might as well own a brick in the wall of their break room. What good does it do you? Why would you invest in something that you KNOW gives a zero percent return? If you say, Because I can sell it to someone else at a profit! But ... why should they buy it? This sounds more like a pyramid scheme than an investment. –  Jay May 8 at 21:35
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I don't think this answers my question. Yes I get that stocks will increase as a company does better and that will allow for higher resell. I'm not asking why I should buy one type of stock or another. I'm asking, on a more fundmental level, what is the force that drive the stock market. For stocks to mean anything more then a fancy sheet of paper they must, ultimately, be able to be converted into cash now or in the future. What intrinsic value does a non-dividen stock have over buying beanie babies or other collectables to resell? Why should company success lead to higher stock value? –  dsollen May 8 at 21:48
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@victor But you're not answering the question. WHY is there a demand for a stock that pays no dividends? What gives it value -- other than as a collector's item? dsollen and I are asking, Why would anyone buy an investment that has no return? To say, "Because other's are willing to buy it from you at a profit" just pushes the question back. Why are THEY willing to buy it? Where does the value come from? –  Jay May 8 at 22:18
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@Jay There are many stocks that don't currently pay a dividend, but I know of none that will certainly never, ever pay a dividend. Same goes for buybacks. Your question is hypothetical if you insist on asking about a stock that will certainly never pay a dividend. As long as there is a possibility for a dividend, or a buyback, or a takeover, the shares of a growing company are likely to grow in line with its earnings, assuming stock dilution is less than its growth rate. –  Chris W. Rea May 9 at 4:58
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@Jay One point to consider: Directors (and, by extension, the executives & managers they hire) have a duty to act in the best interests of shareholders -- a fiduciary duty. So one can't rule out (forever) the possibility of dividends & other liquidity events. Get enough of the shares and you can choose the corporation's directors (or install yourself). And even if you aren't the majority, they are still required to act in your best interests (as part of the aggregate.) So, barring bankruptcy or extraordinary criminal asset seizure, the probability of getting money out should exceed zero. –  Chris W. Rea May 9 at 13:40
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A Company start with say $100. Lets say the max it can borrow from bank is $100 @ $10 a year as Interest. After a years say, On the $200 the company made a profit of $110. So it now has total $310
Option 1: Company pays back the Bank $100 + $10. It further gave away the $100 back to shareholders as dividends. The Balance with company $100. It can again start the second year, borrow from Bank $100 @ 10 interest and restart.

Option 2: Company pays back the Bank $100 + $10. It now has $200. It can now borrow $200 from Bank @ $20. After a year it makes a profit of $250. [Economics of scale result $30 more]

Quite a few companies in growth phase use Option 2 as they can grow faster, achieve economies of scale, keep competition at bay, etc

Now if I had a share of this company say 1 @ $1, by end of first year its value would be $2, at the end of year 2 it would be $3.3. Now there is someone else who wants to buy this share at end of year 1. I would say this share gives me 100% returns every year, so I will not sell at $2. Give me $3 at the end of first year. The buyer would think well, if I buy this at $3, first year I would notionally get $.3 and from then on $1 every year. Not bad. This is still better than other stocks and better than Bank CD etc ...

So as long as the company is doing well and expected to do well in future its price keeps on increasing as there is someone who want to buy.

Why would someone want to sell and not hold one:
1. Needs cash for buying house or other purposes, close to retirement etc
2. Is balancing the portfolio to make is less risk based
3. Quite a few similar reasons

Why would someone feel its right to buy:
1. Has cash and is young is open to small risk
2. Believes the value will still go up further
3. Quite a few similar reasons

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As an owner of a share of a business you also "own" profits made by the business. But you delegate company management to reinvest those profits, on your behalf, to make even more profits. So your share of the business is a little money-making machine that should grow, without you having to pay taxes on the dividends and without you having to decide where to reinvest your share of the profit.

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Yes, I agree with you. Saying that the value of the stock will grow as the company grows and acquires more assets ... I don't see why. Okay, I'm a nice guy and I want to see other people do well, but what do I care how much money they're making if they're not giving any of it to ME? Frankly I think it's like people who buy commemorative plates or beanie babies or other "collectibles" as an investment. As long as others are also buying them as an investment, and buying and reselling at a profit, the value will continue to go up. But one day people say, Wait, is this little stuffed toy really worth $10,000? and the balloon bursts. Confer Dutch tulips: http://www.damninteresting.com/the-dutch-tulip-bubble-of-1637/

As I see it, what gives a non-dividend-paying stock value is mostly the expectation that at some time in the future it will pay dividends. This is especially true of new start-up companies. As you mentioned, there's also the possibility of a takeover. It wouldn't have to be a hostile takeover, any takeover would do. At that point the buying company either buys the stock or exchanges it for shares of their own. In the first case you now have cash for your investment and in the second case you now have stock in a dividend-paying company -- or in another non-dividend-paying company and you start the cycle over.

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Most companies are taken over. One can reasonably guess that company X will be taken over for a price P, at some future point in time. Then the company has a value today, that is less than price P, by a large enough margin so that the investor will likely "make out" when the company finally is taken over at some unknown point in time.

The exception is a company like Microsoft or Apple that basically grow too large to be taken over. But then they eventually start paying dividends when they become "mature." Again, the trick, during the non-dividend paying period (e.g. ten or fifteen years ago) is to guess what dividends will be paid in some future time, and price the stock low enough today so that it will be worthwhile for the buyer.

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up-voted because this was a legitamant answer that got to the heart of my original question and didn't deserve the downvote, though it was a little late ;) –  dsollen Jun 25 at 23:31
    
While I agree with @dsollen - that your answer provides a direct (and concise) response to the original question - do you have any evidence to suggest that 'most companies are taken over'? –  Jubbles Jul 9 at 3:24
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