Reason for a New Age

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Stock: A Primer

Posted by publius2point0 on 2010/01/28


According to the Wealth of Nations, “stock” is named so because traditionally it referred to the goods used to produce products. I.e. the stock of supplies. In his time, that may have been grain or wool, machinery to refine it, and the factory in which it is produced. These days it might be more along the lines of computers and internet bandwidth.

A wealthy man, Arnold, possessing property with a building upon it, and believing that his friend Bill has a good idea for a business might lend him the use of the building in which to start the business. In return, Bill pays him some regular, monthly fee which could be set to eventually cede the property to him, or be assumed to eventually return to the original owner. While Arnold maintains ownership of the property, he can always sell the lease to some third party. The person who buys it knows that he will receive monthly payments for some period of time after which he either gets the property free for whatever use he wishes or earns back more than he paid Arnold for it before the deed to the land passes to Bill’s hands.

You might be thinking to yourself that I’m just talking about rent, leases, and mortgages but the point is that this is how stocks began–though not limited to property like this.

The amount of excess property or other supplies that a wealthy person has to give away is generally going to be fairly limited. He might have extra he could give, but not enough to form the capital for an entirely new business. And of course if he has the sort of supplies that would be useful to a particular business, that’s probably because that’s what sort of business he is already in. He has no great desire to fund a rival.

Dealing in an excess of supplies is fraught with more issues than simply lending money straight. Arnold gives Bill $1000, and Bill uses that money to go out and purchase what he needs from several dozen different sources and start his business with it.

This is just a loan, though, and there are some problems with loans. Most predominately is that in the 19th century, when the Wealth of Nations was written, you may have been liable to have ended up in debtors’ prison. Even if you didn’t, getting in debt is certainly a rather bad thing. The other problem with loans is that they are liable to be based on actuaries, which might, for example, say that your average business lasts less than 5 years–in which case, you have to pay off all of your loan, plus interest, in that small period of time.

What Bill does to solve this, is he goes and finds a bunch of other people like himself, too poor to make a large enough loan to be worthwhile. They don’t have actuaries and they see themselves as having enough to gain as to be willing to possibly throw all their money away. He gets a small sum from each of them and tells them that what he will cede some percentage of the ownership of the business to them. This way there isn’t actually a loan, rather they earn a part of the profits commensurate with their level of ownership.

But how much is that worth? Do you say that whatever the CEO’s salary is, the owners each get a value that is proportioned in relation to that? What happens then when the CEO sells off more stock, does his own salary decrease? Or say that instead you set it based on the profit of the company each year–you can barely sell off more than a percent cumulative among those wishing to buy, or you would be unable to compete.

An enterprising Bill came up with a rather clever scheme. He said to everyone, I’ll sell you 1% of interest in the company for every $1000 you give me. You can take your ownership and sell it to other people or back to me at any point. If the market price for 1% stays at $1000, I’ll give you 10%, or $100 in dividends. If the market price rises to $2000 for 1% ownership, then I’ll give you $200 each year–again 10%. If the company goes broke, then I don’t owe you any money back. If the company never goes broke, you’ll continue to receive your dividends. And of course, if ever the company is purchased, the purchasing party may try to buy out your share since they need a controlling interest, at which point you’ll have received the market price for your ownership, as well as all the dividends up to that point.

Over the years and centuries, however, it was discovered that people chose to largely ignore the promise of dividends. You are banking on the company being either purchased, or being able to fob ownership off onto a second person when the company is valued highly. The modern day rate of dividends is actually only about 2.8%, rather than the 10% I proposed in my example. Bill likes this because it means that he doesn’t have to really give any money to the people who own stocks, just other people or other companies who wish to take the company over.

In the end, a stock’s value is based on the value of the company it is connected to–which we will call Widget MFG–in a fairly roundabout way. The owners guess how much they think another company would pay to purchase a controlling interest of Widget MFG. This company bases that on how much profit they can gain by adding Widget MFG to their roster. As a Widget MFG grows, though, the odds of it being purchased decline. Logically, this would mean that the value of the stock would decline–but of course, if it did, a company could purchase controlling interest, so it ends up stabilizing around some particular value that makes it hard to purchase a company of that size, but not impossible, given the profitability of the company.

For nearly all cases, this is a fairly effective way for an actual, sane market value to be reached. And of course the overall value of the market can be expected to continue growing since loans–which stock are a version of–go into creating new markets or increasing efficiency (e.g. production/cost). Everyone wins.

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