Why does demand for stock rise when a company appears to have high future value?

Question

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?

Answer 1

The primary reason to hold any stock is the expectation that at some point in the future it will return money to whoever is holding it at the time, 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 returned to the shareholders

Just because it isn't paying anything out now, doesn't mean it won't in the future, and even if the current shareholder sells before receiving anything, the next shareholder or the one after that (etc) will get the money.

The hope of those future payouts is what ultimately makes a stock worth something - the current market value fluctuates at least in part based on the expectations of the people buying and selling of what those payouts will be. Even though many people do just trade on sentiment or other factors, it's the fact that stocks have some intrinsic value from those eventual payouts that distinguish the stock market from a Ponzi scheme.

Most successful companies do ultimately pay dividends even if they don't during their growth phase. Typically the management will do this of their own volition, or if not will be pressured by shareholders to do it. There's plenty of material out there emphasising that at least some investors do see dividends as important, for example this Investopedia article.

A secondary benefit of owning stock is the control via voting it gives you of the underlying company. This gives holders the opportunity to influence the direction of the company in a way that suits them - e.g. to encourage earlier payouts of spare cash via dividends. But even if you have 51% of the votes, the other shareholders retain their economic interest in the company - you can't just vote to pay all the money it holds to yourself. If you have 100%, then you can broadly do anything you like with the assets - this is normally how takeovers work.

Answer 2

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.

Answer 3

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.