I is for Investing

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Martha Sadler emailed four simple questions about the stock market to UCSB Professor of finance Rajnish Mehra. Really, it was one basic question that has long puzzled her, asked five different ways. Mehra, whose areas of interest include corporate finance and growth theory, is a research associate at the prestigious National Bureau of Economic Research. The NBER is a private, nonprofit, nonpartisan organization dedicated to promoting a greater understanding of how the economy works. So if anybody should be able to answer Martha’s questions, it is Professor Mehra. Does the strategy work? Does she finally, truly grasp the essential nature of stocks?

How—mechanically speaking—do the average investor’s choices affect the wealth of a given corporation?

A corporation’s value depends on the profitability of its investments. Investors require a rate of return (depending on the risk of a corporation) and price the stock accordingly.

If the prospects of a corporation improve unexpectedly then the expected rate of return on its shares increases. In other words at the current price the rate of return that investors can expect is more than what they require. Additional investors are attracted to the shares, thus bidding up the price and the market value.

What is the essential difference between a stock investment and a side bet in a poker game?

Nothing other than (a) over the long run the expected return on a broad stock market index in real terms has been about 7%. The expected return for an individual poker player depends on the skill of the player. And (b) while all the participants can get—and have been getting—a positive expected return on investments in the stock market, the expected return for all participants in a poker game is at most zero.

To clarify my question: When I buy a stock, the money simply goes to the last person who held it, not to the company’s operating capital. (Please correct me if I’m wrong). Nor do the company’s profits come to me (unless it is a dividend stock). So, all this “investing” seems to have no direct link to the company’s business, but more like audience members betting among ourselves on which business will “win.”

The rate of return on a stock investment depends on the price paid, dividends and capital gains. The price of a stock at any time reflects the expected rate of return that investors require. If the prospects of the firm unexpectedly improve then as stated earlier (in the first question), the price of the stock will increase and the current stock holders will get a windfall gain in addition to the “fair” rate of return. Of course there will be a windfall loss should the prospects decline. Hence the firm’s business decisions have a profound effect on its stock price.

How much does the underlying value of a company—I don’t know what the actual term is, but what I mean is, the amount of profit it could make by selling its wares, now or in the future—have to do with stock value?

The value of the firm is the sum of the present value of the cash flows that it generates in the future. The further into the future a cash flow is likely to be realized, the lower is its present value. Likewise the riskier a cash flow is, the lower is its present value. (Cash flows are related to profit but typically are not the same).

Does the broad stock market index tend to go up because more and more investors are constantly joining in?

No. The index goes up because in a productive economy investors demand a positive rate of return. Why would you buy stocks (or any other form of financial asset) if you did not expect a positive rate of return? Both dividends and capital appreciation contribute to the rate of return.

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