What Does the Share Price of a Public Company Mean?

by Dmitry Chernikov
by Dmitry Chernikov

Everybody’s watching the stock market these days. The correction we are experiencing now makes it especially important to understand what factors determine the share prices of publicly traded corporations. Questions abound. Does the company benefit from or is it hurt by any particular trade? If I buy more shares with my dividends, then my money does not go "into the company"; it goes to the shares’ seller. What gives? Suppose a small company going public issues 1,000 shares. Can it price them at a million dollars each? If not, why not? In what follows I explain how shares are priced.

In order to understand the dynamics of the stock market, it is useful to start with the concept of the evenly rotating economy (ERE). In this "imaginary construction" there is no change in the market data, and time is abstracted from. The same goods are produced and consumed in the same way. There is no difference between today and tomorrow, insofar as we assume, as we are entitled to, that advancing all goods one level down the production structure, and also consumption, take exactly one day. There is no depletion of natural resources. No new technologies are created. There is, most important, no action. The economy is in constant flux, but it always looks the same.

All income is permitted in the evenly rotating economy except business profit (loss is similarly proscribed), because profit is a result of novel human action (so is loss, except there the action is mistaken). This causes investing into a company to be entirely equivalent to loaning money to that company. Suppose that 10 people, Q₁, ..., Q₁₀, each own 100 shares of company A, each share costing $1. Let A also borrow $1,000 from lender P. A’s assets are now $2,000. It uses these funds to buy factors of production and advance them down the production structure by selling its product to the lower-order capitalists or to the consumers. Now a question: How much must A’s revenue be if the interest rate is 5%? Well, in order to continue evenly rotating the next day or next year, A must make at least $2,000. But it also has to pay interest to P which is $50. Moreover, if A distributes less that $5 in interest-equivalent income to each of its shareholders, then these shareholders would be better off getting rid of their investment and loaning the money to some better-performing company B. In order to keep the investors happy, A must also give them at least 5% above the $100 it generates every year for each investor or $5. But since we are not allowing company A to profit, it cannot generate more than $5 per investor income. Overall, A must make $2,100. We can see that in the ERE there is no conceptual difference between investing and lending money for productive activities.

Let’s permit profit to enter into the picture. Suppose that in a certain year company A made $2,300. It decides to give out dividends to each owner. Note that P is not eligible for the dividends; all he receives is interest. How at this point do we distinguish between interest income to Q₁ and profit consumed by Q₁? By counting as profit everything above the interest income. How will the share price change given the profits? Well, the share price is a sum of two components. The first component is the capital owned by the company, that is, A’s assets minus A’s liabilities. That number is $1,000, and so the initial value of a share of A is $1. The second component is the expected discounted future profits of the company. (We have to discount, because $200 received 10 years from now is equivalent to $200/(1.05¹⁰) right now.) Thus, if the profit is expected to be $200/year every year for all eternity, then the total dividends will be D = 200*(1 + 0.952 + 0.952² + ...) = $4,200. The share price will increase to 1 + 4.20 = $5.20. We can say that materially every company is a basket of capital goods it owns; while formally it is entrepreneurial direction of that basket. The share price reflects both matter and form.

What can a company do with its profit? First, it can distribute it to the investors for consumption. Note that it is expectations of future dividends that change the value of each share, not the dividends that have already been given out. Second, it can re-invest the profits into itself or "plow the profits back into the business." This causes the company to grow, where by "growth" I mean capital gains. Instead of buying $2,000 worth of producer goods, as it did last year, A buys $2,150 worth of them. The share price goes up, because its first component increases. If in a certain year the company was expected to produce dividends but instead decided to re-invest the profits, then what happens to the share price is unclear: on the one hand, the expectations were disappointed and so D will be lower; on the other hand, the company has grown. (With more capital A has a chance to attain higher profits in the years ahead. This may increase D relatively: instead of going down to $4,000, the second component may decrease only to D' = 205*(0 + 0.952 + …) = 4,100.) The share price then is an effect not a cause of corporate adventures in the market. It’s entirely a reflection, a sign of the present and expected future state of the company. So, if it is asked: For what reason is the company interested in making its share price as high as possible?, the answer is: because the price is formed as a result of adding (1) the company’s capital and (2) its discounted expected future dividend stream, and the higher the share is, the richer the company owners are: the more "stuff" they own in the form of producer goods now and the more stuff they expect to come to own in the future once the output is produced and sold. This combination can be traded for cold hard cash with other people.

What happens to the shares if the shareholders expect the company to keep losing money for the foreseeable future? They may try to get rid of the shares at bargain rates, given that, in their estimation, there will be no dividends, and the company’s capital will shrink. The shares now may cost less than A’s total capital. They (or the new owners) may try to make changes to the company, such as replace the senior management, seeding the vacant position with better leaders, thereby changing profit expectations. They can, finally, take the company out of business, sell the assets, pay off the debts, and distribute the proceeds.

Trading shares on the stock market happens whenever two people disagree in their estimation of the company’s prospects. The first component of the share price can at any moment be easily ascertained by taking stock of the company’s assets and liabilities. But people can have widely divergent views of how profitable the company is going to be in the future or even whether it will have a future at all. So, when shares change hands, it's not a normal trade, as in the case of trading my apple for your orange. In the latter case there is a double inequality of wants: I prefer your orange to my apple; you prefer my apple to your orange. But in trading shares, only one of us will be revealed to be right as the future unfolds. The share that, were there no uncertainly, would cost $5.20, instead cost $3, when I bought 50 of them. Hence I profited or will have when the money comes in. Whoever sold it to me for $3 lost, because my dividend income stream adds up to more than $2/share. Now it is possible for both of us to benefit, if our time preference rates differ so as to permit a mutually beneficial exchange. (If I discount by 5%, then D for me will be equal to $4,200, as calculated above. If you discount by 20%, then D for you is only $1,200. You need the money "right now" more urgently than I do. You can then sell the shares to me for, say, $3,000, for mutual profit.) But it is also possible that one of us is wrong as to the company’s prospects and is therefore a poor entrepreneur.

Finally, let’s consider how a company raises money in an initial public offering. Let my company be worth, I my judgment, $800,000. I predict or estimate that my company can become quite larger, in fact, larger by $1 million and still profit considerably. I know how to use $1,800,000 well, though I am less confident about how I could use still more money. Moreover, I know that other people will be reluctant to invest too large of an amount with an untested CEO (myself, for example). To attract capital, I issue 180,000 shares, slap a $10 price tag on each, and retain 80,000 of them. The rest I offer for sale. At this moment I own all the shares, but they cost only $4.44 apiece. I raise capital by selling them for more than that, with the condition that all the money received has to become the starting capital. Now suppose that other people overestimate my leadership skills. In that case they might be willing to buy each share for more than $10 each, supplying more than $1 million in capital overall. Even a smaller share of the future profit (which translates into dividends and capital gains) may be valuable, if the profit is expected to be large. If, on the other hand, folks think I’m less alert than I imagine myself to be, then the share price is likely to fall, allowing people to buy the right to a greater share of the capital and profits for less money. My own wealth will fluctuate as a result, as well.

March 7, 2009

Dmitry Chernikov [send him mail] has a Master's degree in philosophy from Kent State University. See his blog.

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