Stock market cycles
The physical stock certificate has no purchasing power. There must be some expected reward or future benefit that will entice investors to part with their money in exchange for the stock certificate. The investor acquires a claim on all future benefits that are transferred from the corporation to the investor. The only benefit that can be transferred from the corporation to the investor is distributions, usually cash dividends. Stockholders rarely receive physical assets, such as a corporate owned car or plant, from the corporation.
The motivation to purchase a share of common stock is the expectation of a return high enough to warrant undertaking the risk associated with the ownership of that particular share of common stock. The motivation to sell the share is the expectation of a rate of return no longer high enough to warrant undertaking the risk associated with the ownership of that particular share of common stock. The relationship between the expected rate of returns and risk changes motivating investors to purchase or sell the share. Skeptics respond that the share of common stock can be purchased for capital gain potential in addition to future dividends. The price at which the common stock may be sold in the future is always a function of the claim on future benefits, namely dividends, expected to be received by the new purchaser. Corporations that will never, with iron-clad certainty, distribute any of its earnings or assets to its stockholders must, with certainty, have a common stock that has no value other than the piece of paper on which it is printed. Most stock certificates are not works of art and, therefore, have no value as a piece of paper.
EXPECTED RATE OF RETURN VERSUS RISK
The expected return must compensate investors for the risk associated with purchasing a particular share of common stock or investors will not buy the share, or if already owned, will sell it. Different company common shares may be compared on an expected return or risk basis. The most attractive shares are those with the highest expected rate of return for the risk or the lowest risk for the expected rate of return.
The common shares of different companies compete for investors limited funds on this expected rate of return or risk basis. Investors continually seek the most attractive expected rate of return or risk relationships and continually adjust their common stock portfolios by exchanging among common stocks and between other categories of assets. This equilibrating process is typically called fungibility, the exchanging among competing shares and other assets by investors in search of the most attractive expected rate of return or risk relationships. The concept of fungibility is applicable to all financial assets, particularly among publicly-traded common stocks since they are homogenous financial assets. Investors considerations are in monetary terms. Investors purchase in dollars; investors receive benefits in dollars; and investors sell in dollars. There are no non-monetary benefits to common stock ownership. Common stock purchases and sales, motivated purely by the monetary expected rate of return or risk relationships. The prices of common shares continually change to reflect changes in the expected rate of return and the risk in an attempt to find equilibrium. The expected rate of return must be equilibrium compensation for the risk.
Expected future benefits
The expected future dollar benefits to be received by stockholders are dividends. They are the only benefit that can be transferred directly to the shareholder from the corporation. Dividends are paid out of earnings. So investors must look so earnings as the generator of expected future benefits. The natural consequence is that investors expend vast time and energy analyzing and forecasting earnings, particularly earnings per share. Corporate managements also spend energy and time on reported corporate earnings per share. Management must eventually transfer benefits from the corporation, a separate legal entity from stockholders, so the common share may have value. The share purchased is only a claim on future, expected dividends. If none is paid, the shareholder claim is worthless. Of course the shareholder may prefer that dividends be postponed while the corporation reinvests retained earnings to grow the expected dollar amount of future dividends.
Future
The expected earnings and dividends generated as expected benefits to the shareholders must occur in the future. Past dividends belong to the past, even perhaps to a prior shareholder. A new shareholder cannot demand past dividends already received from a prior shareholder. The claim on dividends accompanying any share is a future claim. A dollar received in the future in the future is not worth as much as if it were received today. This is the concept of present value.
Present value
Why is a dollar received tomorrow not worth as much as a dollar received today ? The wait is costly. At the very least, interest is lost. Investors pay a lower price for a claim on future dividends than the dollar amount of those expected dividends. The lower price is compensation for lost interest and the risk of waiting. Investors also run the risk, particularly in common stocks that adverse events might occur during the wait. The dividends actually received might be lower than the dividends expected when the common shares were bought. The common stock price will probably be lower if this occurs. The future claim on dividends is infinite. Investors can own the shares forever. The shares are never intended to be redeemed. The expected life of the corporation is perpetuity. Publicly-traded companies rarely plan to remain in business for a limited number of years and then dissolve. Buying a share of common stock really means investors could perfectly foresee the future dividends, they could readily calculate the intrinsic value of the common shares at any particular discount rate. Such foresight is not possible.
Discounting
The required rate of return that compensates shareholders for the lost interest and risk of the wait discounts future dividends to the present. The lost interest can be measured by the yield to maturity on a United Stated Treasury bond. The specific maturity varies among investors. However, long term bond yields are probably the best proxy for lost interest since their maturities are closest to the assumed, infinite life of the common stock. Expected dividends beyond the long term bond maturity have little impact on the present value of the common share at almost any historically observed required rate of return discount. There is no impact on the current common stock price because those dividends are expected so far in the future. The required rate of return must be increased beyond the long term United States Treasury Bond yield to include the risk that expected dividends might not be received. The required rate of return is the discount rate used to calculate the present value of the expected dividends. The required rate of return reflects all risks associated with common share ownership.
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