A shareof stock is for its buyer a share just like a stake in any other share system: the compensation of a loan, prorated on capital growth. The loan is granted by an investor in a corporation. There is no transfer of ownership of the capital; there is a transfer of usage of the cash. The shareholder remains the owner of the advances he or she is making to the corporation.
However, things can get complicated if and when the company goes bankrupt. In such a case, all loans from shareholders to the corporation
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come to an end. Yes, the company pools its assets—including all investors’
contributions—in anticipation of distributing them on a proportional basis among its shareholders. Here’s the bad news from an investor’s standpoint:
Shareholders’ rights to assets cannot be exercised until after the corpora- tion’s creditors have been compensated. This makes sense if one acknowl- edges that the company’s debt is nothing but the loans it has obtained from other sources—loans on which it pays rent in most cases. In other words, you have to pay off your debts before you can fairly assess your riches.
Back to the nonbankruptcy scenario: The share’s return is typically dis- tributed as an annual dividend. Dividends constitute a set proportion of the net earnings (capital growth) that the company has managed to make with the help of the contribution in capital that the share represents. It is logical, therefore, that the shareholder receives a dividend only if the company has made a profit over the preceding year. In other words, you get a dividend only when your contribution in capital has managed to grow.
The price paid by an investor for a so-called common share of stock is the price paid for a share in a corporation’s capital growth. The price of the share is the price of the advancemade to the company to provide it with the cash needed to perform its business.
There is another kind of stock that we need to take a quick sideways look at before this chapter comes to an end. This is the so-called preferred stock. A preferred share is actually not a share at all in the sense that I have been using the term in this chapter. It is actually a form of debt incurred by the corporation that is prorated on the capital’s face value rather than on the company’s capital growth. The dividend paid on a preferred share, in other words, amounts to the payment of rent.
Watch what happens the next time a major corporation goes under.
Almost inevitably someone will complain about the “preferred sharehold- ers” getting their needs met before anyone looks after the needs of the
“common shareholder.” No matter that the corporation has entered these obli- gations with its eyes open. No matter that, for the most part, preferred share- holders (unlike common shareholders) hold nonvoting stock and therefore have no say in the overall direction of the corporation. People almost cer- tainly will wonder out loud who these preferred types—read “fat cats”—are.
And this is one justification for including this chapter on the realities of rents and shares and bonds and stocks. Before you can deal with the com- plexities of the universe populated by the Enrons, WorldComs, and so on, you have to understand the fundamentals on which that universe is based.
LESSONS FOR THE INVESTOR
Understand your options as an investor.There are two ways of being compensated for a loan to a corporation: charging rentpro- rated on the loan amount or claiming a share of capital growth.
When charging rent,investors are only exposed to default of the borrower, which means that their risks are relatively low. At the same time, they do not stand to benefit from potential capital growth. When holding a share,the investor (the capitalist) shares capital growth with the borrower (the entrepreneur).
Understand how your advantage shifts in changing corporate and economic circumstances.With low capital growth, it is in the interest of the investor to buy corporate bondsand in the interest of the entrepreneur to issue shares of stock. With high capital growth, it is in the interest of the investor to buy shares of stockand in the interest of the entrepreneur to issue corporate bonds.
Issuing shares of stock may be advantageous to the entrepre- neur.The entrepreneur will never incur a loss when issuing shares of stock but may incur a loss when issuing corporate bonds because—once again—the rate of capital growth of his or her busi- ness may be lower than the corporate bond’s coupon. And issuing shares of stock instead of corporate bonds reduces fluctuation in returns (or volatility).
Bonds, although never popular during bull markets, hold some clear advantages to the investor.True, bonds cut the investor out of the capital-growth calculation, but they allow the investor to fix his or her future revenue at the time the contract is purchased.
(Those seeking a dependable source of income or those who antic- ipate a significant cash payment—such as a tuition payment—in the near future therefore prefer bonds.) And if and when a corpo- ration gets into trouble, the bondholder is first in line. A share- holder’s right to a corporation’s assets is a right to its actual wealth, meaning after debt has been accounted for.
Not all stock shares are true “shares.” Preferred stock is actually a type of debt and typically is a nonvoting stock (but make sure to read the fine print!).
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The Price and Value of a Share of Stock
Dividends historically represent the dominant part of the average return on stocks. The reliable return attributable to dividends, not the less predictable portion arising from capital gains, is the main reason why stocks have on average been such good investments historically.
—ROBERT J. SHILLER, Irrational Exuberance1
What makes for value in a share of stock, and how does that relate to the price of that share? Surprisingly, the answers to these questions are not always obvious. In fact, they have been the basis of heated debate in recent decades. As we work our way toward investment strategies in the post-Enron world, let’s reflect briefly on the value-price relationship.
The two predominant views about the value of a share of stock are the dividend-stream theory and the castle-in-the-air theory.2The dividend- stream theory has a number of alternative names, such as the fundamentals
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explanation of stock price,the firm-foundation assessment of price (Burton Malkiel),3 the expectations theory (Alfred Rappaport ),4 and so on. With small variations, these are the same.
The dividend-stream theory and the castle-in-the-air theory are usually presented as competing notions. Very briefly, the dividend-stream theory holds that the fair price of a stock is the present value of all future cash flows
—in other words, all expected dividend payments and a final proportional share in the asset value of the company, should it choose or be compelled to liquidate. (I will return to the dividend-stream theory later.) The castle-in- the-air theory, credited to John Maynard Keynes, holds that there is no such thing as a fairor rational price for a share of stock and that price translates into—bluntly put—whatever the next sucker is prepared to pay. Logically, there is no immediate valuation of a share of stock in the castle-in-the-air theory; and in fact, it is not really a theory at all. It is more an expression of despair about the seeming impossibility of objective valuation.
Neither of those two views is wrong, and to see them as competing views miscasts the role they play within an overall framework. As I will argue in this chapter, the dividend-stream theory should govern a stock’s initial price—that is, the price it commands on its initial public offering (IPO). The castle-in-the-air theory accounts convincingly for the price of a share of stock on the secondary market for stocks, also called the aftermarket,when a buyer purchases shares on the open market from a seller. (As a general rule, indi- vidual investors acquire their stock on the secondary market.) Unfortunately, the reason why the castle-in-the-air theory accounts fairly well for the price of many stocks is that they are caught in a speculative bubble—and a stock in a speculative bubble is truly a castle in the air.