Subject: Stocks - Price Basis

Last-Revised: 28 Oct 1997
Contributed-By: George Regnery (regnery at yahoo.com)

This article presents a bit of finance theory, namely the basis for a stock's price.

A stock's price is equal to the net present value (NPV) of all expected future dividends. (See the article elsewhere in the FAQ for an explanation of the time value of money and NPV.) A company will plow its earnings back into the company when it believes it can use this money better than its investors, i.e., when the investment opportunities it has are better than its investors have available. Eventually, the company is going to run out of such projects: it simply won't be able to expand forever. When it gets to the point where it cannot use all of its earnings, either the company will pay dividends, it will build up a cash mountain, or it will squander the money. If a company builds a cash mountain, you'll see some investors demand higher dividends, and/or the company management will waste the money. Look at Kerkorian and Chrysler.

Sure, there are some companies that have recently built up a cash mountain. Microsoft, for instance. But Gates owns a huge chunk of Microsoft, and he'd have to pay 39.6% tax on any dividend, whereas he'd have to pay only 28% (or perhaps 20%) on capital gains. But eventually, Microsoft is going to pay a dividend on its common shares.

From a mathematical perspective, it's quite clear that a stock price

is equal to the NPV of all future dividends. For instance, the stock price today is equal to the NPV of the dividends during the first year, plus the discounted value of the stock in a year's time. In other words, P(0) = PV (Div 1) + P(1). But the price in a year is equal to the NPV of dividends paid during the second year plus the PV of the stock at the end of two years. If you keep applying this logic, then the stock price will become equivalent to the NPV of all future dividends. Stocks don't mature like bonds do.

Of course it's also true that a stock's price is equal to whatever the market will bear, pure supply and demand. But this doesn't mean a stock's price, or a bond's price for that matter, can't have a price that is determined by a formula. (Unfortunately, no formula is going to tell you what dividend a company will pay in 5 years.) A bond's price is equal to the NPV of all coupon payments plus the PV of the final principal payment. (You discount at an appropriate rate for the risk involved). Any investment's price is going to be equal to the NPV of all future cash flows generated by that investment, and of course you have to discount at the correct discount rate. The only cash flows that investors in stocks get are from the dividends. If the price is not equal to the NPV of all future cash flows, then someone is leaving money on the table.

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