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In a very basic sense, stock is purchased for the ownership of a company. Its price grows on the market following supply and demand, and as such the price of a single share may rise as the value of a company rises and more people want to buy that share than those willing to sell.

But why is the portion of a company granted by that share worth less than what it’s paid for?

Suppose a company has a book value of $180M and has 100M shares outstanding on the market for $5. Its market cap, which encompasses its intangibles and growth potential is nearly 3x as much as its book value, signaling the market believes the company is and will continue to do well (in theory).

Now since a share indicates owning a portion of the company, a single share in this company is worth 0.00000001%, or if the company liquidated its assets today, $1.8; so why would somebody want to buy a share of a company for more than what that share is worth? Is the delta between its intrinsic value and the market value the “mark up” for the current shareholder to earn for giving their position away?

This brings up the question, if you exclude capital appreciation from the equation, if the share price on the market is more than the intrinsic value it loses at purchase, the hope would be that over time the value of the company grows such that the share's intrinsic value eventually exceeds what you paid for it, right?

So in the event a company closes shop, I may not recoup my entire investment but I would at least get something, so I suppose the mark up was for the potential the company had?

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  • Intrinsic value is a guess, and is meaningless. The price of a company share (what someone most recently paid for it: hence assuming it will go up) is a guess, and is meaningless. It is comparing two meaningless values!
    – Fattie
    Apr 4 at 14:39
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If I understand your question correctly, you are asking: "why would anyone pay above book value?"

Imagine a fictional world where bank accounts are tradable. All bank accounts in this fictional world are risk-free, and pay a yearly interest of 2%. Suppose I have a $100 bank account. The book value of this bank account is $100. How much would you be willing to pay to buy my bank account? Answer: $100.

Instead, suppose I own something rare: a $100 bank account that always pays a yearly interest of 5% (instead of 2%). The book value of this bank account could be $100, but how much would you be willing to pay for this bank account? Answer: definitely more than $100.

The difference between the market price and the book value can be seen as the market's appraisal of the value of the company that is not included in the book value. Not all book values are created equal. Some book values may create greater percentage earnings than other book values. The price above (or below) book value that people are willing to pay is a reflection of this fact.

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"Book value" is the sum of the individual assets of a company. But the whole point of the existence of the company is that the specific combination of those assets - in the hands of the owners - is worth MORE than the sum of those individual assets. Otherwise, why create the business at all? In this case, "worth more" means "will generate more value over time."

This is actually one of the important ways that the economy grows: People take assets that are separate and put them together into a company that makes them worth more together than they were apart.

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Book value or liquidation value can be considered a mininum value of a company. Closing down a company generally destroys value by foreclosing all the future profit potential.

As I wrote here:

Generally, healthy companies have a market value well above their liquidation value due to their future potential. This is the market telling them it would be irrational to liquidate.

Another way to look at it: You cannot replicate an existing successful business just by buying an "equivalent" bundle of tangible assets. Your new business will not have the brand, reputation, and customer base that the existing one does, and thus will not have the same profitability.

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Unless you buy bonds or preferred shares, you're not going to get a dime of your investment back if the company goes under. If you aren't in the priority queue of creditors and bondholders, there wouldn't be anything left to parcel out to common shareholders at the end of the day.

The reality is, stocks tend to trade based on what investors see as their potential future value, which sometimes (if not frequently) has little correlation with a company's actual intrinsic value.

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  • 2
    "you're not going to get a dime of your investment back" -- but the reason for that is that companies generally don't liquidate unless they're insolvent. If hypothetically a solvent company did liquidate, common shareholders would get somewhere around book value. It's just that this would be an irrational thing to do.
    – nanoman
    Apr 3 at 3:05
  • Then when do people buy stocks in the hopes that they will have higher dividends later? To receive dividends you must hold the stock and have some sizable investment in them; until the dividends pay back the cost of investment, you’re at a loss. Only after the initial investment are you at a profit, right? Speculation that higher dividends will pay is a reason stock prices rise, some somebody at some point expects to pay $X for stock and over time receive $X+$Y in terms of dividends if they don’t plan to sell their positions.
    – pstatix
    Apr 3 at 3:44
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    The average investor doesn't buy stocks primarily because of their dividends because, as you pointed out, it takes a large holding of shares to make that meaningful in terms of return. Some people like the certainty a dividend provides (at least some tangible predictable return on their money). You aren't at a "loss" unless the market value of shares drops below what was paid. People buy stocks because they believe in future valuation of shares based on the company's prospects (profitability, mergers, market growth, etc.), not because of the liquidation/breakup valuation of the company.
    – RiverNet
    Apr 3 at 11:20
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Suppose you buy 0.1% of a 100-acre farm that has a "book" value of $100,000. That farm earns (after expenses) $10,000 each year for a 10% return on its book value. Where do you think those profits go? Wouldn't your 0.1% of that farm be worth more than the $100 "book value" if it earns 10% per year?

Does it matter to you if the farm keeps that money to buy more land or equipment to keep growing?

It's the same for stocks in companies. People pay more than "book value" because in addition to that value, there's the potential for further growth. If a company earns 10% a year and puts it all back into the company, then the book value of the company in one year would be 110% of its current book value. If instead it gives the 10% to its shareholders, then your share should be worth the equivalent book value plus the 10% dividend you should expect. So you shouldn't care (from a wealth standpoint) whether the company reinvests the income or gives it out as dividends.

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The book value is the amount that you would get if you sold off all the assets and closed down the company. By doing that, you would destroy all the company’s value as a money making machine.

There is another term: “Enterprise value” which is market caps minus book value. And it is exactly that: The value of the business. The value of the employees making money for the company every month, the value of the brand, the customer base and so on.

I mean if you don’t want to pay for the enterprise value, that is up to you, but you will not be able to buy any shares except in the most decrepit companies.

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