Stocks and Shares

Traditional Investments and Timber

The price of a share of stock, like that of any other financial asset, equals the present value of the expected stream of future cash payments to the owner. The cash payments available to a shareholder are uncertain and subject to the earnings of the firm. This uncertainty contrasts sharply with cash payments to bondholders, the value of which is fixed by contractual obligation. Most of the cash payments to stockholders arise from dividends, which are paid out of earnings, and distributions resulting from the sale or liquidation of assets.

Over time most firms pay rising dividends. Rising dividends occur for two reasons. First, firms rarely pay out all their earnings as dividends, so that the difference, called retained earnings, is available to the firm to invest. This, in turn, often produces greater future earnings and hence higher prospective dividends. Second, the earnings of a firm will rise as the price of its output rises with inflation. Firms may also increase their dividends due to growth in the demand for their products and increased efficiencies of operation. These are the firms, of course, that investment advisers seek out when recommending stocks.

Stocks and Shares

Cash payments to shareholders also result from the sale of some of the assets of the firm, outright liquidation, or a buyout. A firm may sell some of its operations, using the revenues from the sale to provide a lump-sum distribution to stockholders. When a firm sells all its operations and assets, this total liquidation results in a cash distribution after obligations to creditors are satisfied. Finally, if another firm or individual purchases the firm, existing shareholders may be eligible to receive cash payments or securities that can be sold in the open market for cash.

Some firms do not pay dividends but use their earnings to purchase their stock on the open market. Since this reduces the number of shares outstanding, the remaining shareholders each own a greater percentage interest in the assets of the firm. Therefore, the price of a stock can rise even if the firm does not pay a dividend and never intends to do so. If and when the assets of these firms are sold or liquidated, a cash distribution will be made and shareholders will realize a capital gain.

Some firms pursue this policy to enable their shareholders to realize lower taxes, since taxes on capital gains are deferred and often paid at a lower rate. The total return from owning stock arises from two sources: dividends and other cash distributions, and capital gains. A total return index for stocks can be computed by assuming that all cash distributions and capital gains are continually reinvested in the stock.

This index would be akin to the accumulation of a pension plan that reinvested all dividends and capital gains in the stock (or group of stocks), or to the reinvestment of all distributions back into a mutual fund. When purchased at a P/E10 valuation of 14 (a moderate valuation level), the most likely 10-year return on an investment in S&P; stocks is 6.3 percent. When purchased at a P/E10 valuation of 27 (the valuation level that applied in March 2007, when this article was posted), the most likely 10-year return on an investment in S&P; stocks is 1.1 percent.

Those are greatly differing value propositions. For most investors, there are some valuation levels at which it makes sense to buy more stocks and some valuation levels at which it does not make sense to buy more stocks. Predicting stock returns lets you know whether buying more stocks at the price level being offered to you at a particular time is a good idea or not.