A Random Walk Down Wall Street
Stocks for the Long Run
Famous First Bubbles
Social Security: The Phony Crisis
On Money and Markets: A Wall Street Memoir
To most observers of the ups and downs of today’s stock market, it defies common sense when eminent economists assert that the stock market works according to logical principles. But most economists believe just that. According to generally accepted economic theory, stocks have a true or intrinsic value.
This value is based on several factors, the first of which is a company’s dividends. In the long run, a shareholder who holds on to a company’s stock can extract a certain cash value from it only when the management returns profits in the form of dividends to its owners. Today, of course, investors buy many stocks, such as Microsoft and Cisco Systems, that do not pay dividends. These companies are growing so rapidly that they continuously reinvest their profits in new products, research, and expanding productive capacity, and investors generally believe their stock prices will rise as they generate more profits. But eventually, even these companies, or so it is presumed, will begin to pay out part of their earnings in the form of dividends as their businesses mature. If Microsoft, for example, retained all its earnings even as its core businesses grew more slowly or stagnated, investors might sell the stock. If they were to hold on to the stock, they might demand some of those earnings in the form of dividends so that they might invest elsewhere (even though they would have to pay taxes at ordinary rates on dividends rather than lower capital gains rates on a rising stock price).
General Electric, for example, is a widely admired and fast-growing company, which no longer mostly makes electric turbines but also owns, among other businesses, a large credit company as well as NBC. But it is also a mature company which prudently pays about half of its profits to investors in the form of dividends—fifty-five cents a share, a little more than 1 percent of its recent stock price. For the economist, the value of GE’s stock depends on future dividends. When analysts devise mathematical models to determine the value of GE’s stock, they usually assume that dividends will grow at about the same rate as profits. Because future dividends are so closely related to profits, if the outlook for profits falls, investors should pay less for stocks.
Money also has a time value, however, and this second factor significantly affects the current valuation of a stock. You will not pay a dollar today for a dollar in dividends twenty years from now because you can earn interest income on today’s dollar. Therefore, when interest rates rise, stock prices will usually fall because dividends to be received in the future will be worth relatively less. (Rising interest rates may also reduce corporate profits, because the cost of borrowing rises.) When interest rates rise, investors will usually pay less for stocks because they can earn more on their money from interest in bonds. A stock price can be seen theoretically as based on …
This article is available to online subscribers only.
Please choose from one of the options below to access this article:
Purchase a print premium subscription (20 issues per year) and also receive online access to all all content on nybooks.com.
Purchase an Online Edition subscription and receive full access to all articles published by the Review since 1963.
Purchase a trial Online Edition subscription and receive unlimited access for one week to all the content on nybooks.com.