Well, for stock values we can regard the future profits of the company as an income stream (or, more generally, as a distribution over the space of possible future income streams), and argue that, given a certain time discount rate and risk aversion, a rational investor (in the sense that other preferences would be self-inconsistent) ought to be indifferent between that income stream and some (finite as long as the income stream's future growth rate is sufficiently small and interest rates do not asymptotically approach or reach zero) lump sum in the present. Thus, a sole proprietor owning a business can, in principle, given some set of expectations for the future, place a dollar value on it.
Now, suppose it's a publicly traded corporation. Internally, it still functions a lot like the sole proprietorship does: it hires people to do stuff, and sells some product, and hopefully makes a profit. Now, though, the management and the owners are in general different people, and the profit has to ultimately get to the owners somehow. For example, it can pay dividends to the stockholders. Then, being a 1/N stockholder gets you an income stream 1/N of what total ownership would get you, and so there's some 'rational' price for a 1/N share just as in the sole proprietor case as argued above.
Now, notice two things: first, the company doesn't have to spend all of its profits paying a dividend. It can also keep some in cash, or spend it expanding itself. Why should it do that? Because it has growth opportunities, or faces uncertainty about its future income stream and wants to hold liquid assets to buffer it, and that profit it just made is an easier source of capital for those purposes than issuing more shares or borrowing from a bank would be. A sole proprietorship would face the same choice on a logical level: if it makes a profit, whether to keep that in the business or transfer it to the owner personally, even though there isn't a *legal* distinction between the two.
In steady state, there wouldn't be any growth opportunities and there would be a certain finite amount of liquidity needed to buffer all expenses to a given confidence level for a given expected mean and variance of income and expense, so we can regard a 'mature' business as one that has reached this steady state and should try to return all profits to its owners, but an immature business would still have growth opportunities and should hold on to most of its profit. Of course, we can distinguish different points on a continuum between these extremes. Even old, mature businesses which have no growth opportunities in terms of introducing new products or improving their products or whatever would still have slow growth due to population increase, after all. I suppose the ultimate question is whether the expected return on re-investing a dollar at the margin into the business is higher than that on returning it to the stockholder so she can invest it elsewhere.
So, logically, the company faces a choice of how much of its profit to reinvest into itself and how much to return to its stockholders to use for other purposes, and this is independent of its form of ownership. The method of effecting that return varies a lot, though. For a sole proprietorship it's as simple as transferring from one bank account to another; for a corporation, it could pay dividends, but current tax laws make this a pretty inefficient method. Thus, most companies try to buy back their own shares instead, and if the efficient market hypothesis is true, then the market capitalization of the company should decrease by exactly the amount they spend doing so, and they've transferred that amount to the stockholders that just sold their shares.
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timeasmymeasure
no subject
Date: 2010-04-03 11:22 pm (UTC)Now, suppose it's a publicly traded corporation. Internally, it still functions a lot like the sole proprietorship does: it hires people to do stuff, and sells some product, and hopefully makes a profit. Now, though, the management and the owners are in general different people, and the profit has to ultimately get to the owners somehow. For example, it can pay dividends to the stockholders. Then, being a 1/N stockholder gets you an income stream 1/N of what total ownership would get you, and so there's some 'rational' price for a 1/N share just as in the sole proprietor case as argued above.
Now, notice two things: first, the company doesn't have to spend all of its profits paying a dividend. It can also keep some in cash, or spend it expanding itself. Why should it do that? Because it has growth opportunities, or faces uncertainty about its future income stream and wants to hold liquid assets to buffer it, and that profit it just made is an easier source of capital for those purposes than issuing more shares or borrowing from a bank would be. A sole proprietorship would face the same choice on a logical level: if it makes a profit, whether to keep that in the business or transfer it to the owner personally, even though there isn't a *legal* distinction between the two.
In steady state, there wouldn't be any growth opportunities and there would be a certain finite amount of liquidity needed to buffer all expenses to a given confidence level for a given expected mean and variance of income and expense, so we can regard a 'mature' business as one that has reached this steady state and should try to return all profits to its owners, but an immature business would still have growth opportunities and should hold on to most of its profit. Of course, we can distinguish different points on a continuum between these extremes. Even old, mature businesses which have no growth opportunities in terms of introducing new products or improving their products or whatever would still have slow growth due to population increase, after all. I suppose the ultimate question is whether the expected return on re-investing a dollar at the margin into the business is higher than that on returning it to the stockholder so she can invest it elsewhere.
So, logically, the company faces a choice of how much of its profit to reinvest into itself and how much to return to its stockholders to use for other purposes, and this is independent of its form of ownership. The method of effecting that return varies a lot, though. For a sole proprietorship it's as simple as transferring from one bank account to another; for a corporation, it could pay dividends, but current tax laws make this a pretty inefficient method. Thus, most companies try to buy back their own shares instead, and if the efficient market hypothesis is true, then the market capitalization of the company should decrease by exactly the amount they spend doing so, and they've transferred that amount to the stockholders that just sold their shares.