Buying an Equity Is Taking an Educated Guess at Future Outcomes
A student in my portfolio management class asked me how a stock could have any value beyond the value of its dividends, unless the stockholder has a controlling stake in the company. According to my student, if the company retains all its profits, the company’s equity might grow but it won’t automatically make shareholders wealthier without a direct link between share price and company performance. Even worse, why bother investing in stocks at all if the future will always be unknowable?
The Link Between Profits and Share Price
My student does have a point: We minority shareholders, who want to profit from stock without buying control of the company, have only two sources of return from our investment. We may receive dividends, if the company decides to pay them, or we can sell our shares. If there’s no link between a company’s profitability and shareholder wealth, buying a no-dividend stock is playing the “greater fool” game, where investors buy a stock hoping that someone will come along to buy it at a higher price than what they originally paid.
There are two ways profitability finds its way into stock price. The first comes from the possibility of dividends in the future. The more likely it appears a company will begin paying a dividend, the more shareholders will be willing to pay for the stock. Another driver of stock price, and usually the most influential, comes from the possibility of the company being taken private or bought by another company. That can only happen when a buyer obtains enough shares of a company to control its day-to-day operations.
Amazon (ticker: AMZN) doesn’t pay a dividend, but it generated $19.4 billion in free cash flow in 2018. Free cash flow is the cash generated from operations minus capital expenditures, the expenses needed to maintain and expand a company’s production capacity.
If Amazon shares were priced at $1 a share, it would only cost $252 million to gain control of Amazon, since there was an average of 502 million fully diluted shares of the company last quarter. It makes no sense that $252 million, the cost to buy a controlling stake of Amazon at a dollar a share, should buy control of $19.4 billion in cash flow. So share price should be related to the company’s ability to generate profits along with additional assets or cash that would be under a buyer’s control.
Additionally, stocks are perpetual. As long as Amazon continues to operate, shareholders will have a claim on the company. So we’re not simply looking at one year’s free cash flow, we’re valuing all the expected free cash flow. If we believe AMZN’s future cash flow will grow, a share will be worth more. If we think that cash flow will dwindle, that share will be worth relatively less.
Investing When the Future’s Uncertain
Where my student got it wrong was the fact that uncertainty isn’t the same as futility. We live with uncertainty every day and, for the most part, we humans are pretty good at managing it. Picture going on a date or buying a house. There are an infinite number of potential outcomes for both. You could have a bad date or find the love of your life. Your home can appreciate in value or a tree might fall on it. But plenty of people continue to go out on dates and millions of homes change hands every year.
The reason stock prices fluctuate so much is that buyers with incomplete information are constantly aligning their money with their fear and greed, and that drives the supply and demand for the stock. The more demand there is for the stock, the more the price rises, and vice-versa. What we investors do, consciously or not, is weight the probabilities of different outcomes and estimate their values.
For example, if you believe a stock priced at $1 has exactly a 50% chance of doubling the next day and a 50% chance of being worthless, you should be indifferent to buying it. Mathematically, the stock’s value is the total of the two potential outcomes after their likelihood is taken into account:
$0.00 x 50% = $0.00
+ $2.00 x 50% = $1.00
In the real world, there are theoretically an infinite number of potential outcomes, and we’re less sure of the likelihood of any of them coming true. But if we’re more right than wrong, we will still make money.
To answer the student’s questions, yes, there is only an indirect link between profitability and stock price, and, yes, the future might be uncertain. But neither of those conditions should hold us back from investing.