I'm an idiot; economic experts please help

Ok, maybe some you economic types can help me, but I don’t really understand stocks.

This is my probably flawed understanding.

A) Stocks are supposed to represent the value of a company.
B) Shares of stocks allow you to easily divide up ownership of a company.
C) A company pays out dividends to shareholders based on profits (there’s probably some legal minimum %, y/n?).

If A, B, and C are correct, when you’re investing in a stock, shouldn’t the expectation be to make money from the dividends? Shouldn’t that be what the stock system is rewarding: lasting wealth creation? So if I buy a stock at X price, I should be looking to make my money back in Y dividend payments and the rest is profit. Instead, it seems everyone makes money off price fluctuation of the actual stock.

How does this benefit the company? Let’s say I own 5 shares of Acme Prank Products which I paid 10 dollars a share for when APP went public. Let’s say I sell them a month later for 15 dollars a share. Since I own the share, don’t I make 5 dollars a share minus transaction fees and taxes? How does Acme Prank Products see any of that money (other than in the initial stock offering)?

I often see investing (buying and selling of stocks) described as capital allocation, but if the seller keeps all the money, how does that transaction allocate more capital to the company? Does the company gather more capital by just increasing (or splitting) the number of shares available? Won’t that piss off current shareholders?

If that’s how it works, it seems like a really crappy system if stability is your goal.

I know I’m revealing my ignorance, but whatever, everyone already knows that, but I’d appreciate the help. If you feel the need, ridicule away. :)

C) A company pays out dividends to shareholders based on profits (there’s probably some legal minimum %, y/n?).

You can pay whatever you want to pay for dividend as far as I know. There could however be nations where this isn’t the case with regards to dividend tax.

Instead, it seems everyone makes money off price fluctuation of the actual stock.

The first type are investors. The second type are traders. People who invest in stock just to sell it later (be it short or long) aren’t really investors at all because they don’t really care about the company itself and they make money from a trade, not the thing they invested in. This of course is the vast majority of “investors” in existence. The only real investors are the founders of a company usually.

How does Acme Prank Products see any of that money (other than in the initial stock offering)?
They don’t. Atleast not directly. Rising stock however does mean that any stock sold after the intial offering can be sold for more.

Does the company gather more capital by just increasing (or splitting) the number of shares available? Won’t that piss off current shareholders?

No, splitting doesn’t change the actual value of a company at all. It just lowers prices on shares (or raises with a reverse split). Link.

They don’t see any of the money, but if their stock tanks, their investors might get upset about it and apply pressure to management to fix the perceived problem, so the company still has an interest in keeping their stock price high. Also, I presume that since many U.S. companies seem to reward their employees with stock options or grants, a low stock price would hurt morale.

Lots of people make money on dividends. It just depends how you want to invest. Relatively new companies generally don’t pay dividends and funnel their profits back into the company to try to spur growth. If you’re buying a stock like this, you’re hoping that the company will grow rapidly and the stock price will increase. If you’re buying stock from an established company like Coca Cola, you aren’t expecting a whole lot of growth, barring some exceptional event. But they pay about a 3% annual dividend, so you don’t need that much growth to stay even with the market.

And afaik (and I very well could be wrong), there’s no requirements on giving out dividends. It’s at the discretion of the board of directors whether it would make investors happier to give out dividends or reinvest profits back into the company. If a company is making decent profits, not giving out dividends, and showing sluggish growth, expect shareholders to look for new management that will either improve growth or start giving out dividends.

There are also the implications of the stock price on buying other companies (or being bought). A company which controls a lot of its own stock can buy another company with a “stock swap” where the buying company pays the shareholders in the acquired company with its own shares (if I understand correctly).

Also, a higher share price for a company makes it more difficult to be acquired in a hostile takeover.

I think A is a bit wrong too, or at least misleading. Stock prices reflect several factors, of which the direct value of the company is one. It’s future earnings potential is another. It’s perceived value is another. That’s why stocks can be inflated relative to the actual capital of the company.

You need to play the wonderful Wall Street raider. I think I’ve seen you lurking in dwarftown so you can’t be averse to text interfaces.

It is definitely true that many people make money from dividends. However, dividends are generally for long-term stock holdings and companies are not required by law to produce a quarterly dividend. You get a much higher return by buying stocks low and selling them high.

Generally dividend-heavy portfolios are considered conservative and usually have much lower returns than carefully managed short-term buy/sell portfolios.

I personally prefer high dividend stocks because I’m not interested in gambling with my money, but still need at least a 12% return to be on track for retirement.

And to be perfectly blunt, no, the stock market as it stands is not conducive to short term stability. Long term stability, yes, and by long term I am talking about periods of 50-100 years. Great for the multi-generational investor, not so great for the medium-term retirement investor who is at the whim of speculative business cycles.

Just to add–splitting your stock makes it easier for investors to buy. If Microsoft never split its stock, each stock would probably be in the 6 figures to buy by now. Small investors just couldn’t afford that, so keeping your stock price under $150 is common.

Which makes one wonder why Berkshire Hathaway is so opposed to it.

Because they are economic elitists who prefer higher barriers of entry to their club? They probably also oppose things like fractional stocks and other instruments that make it easy for large numbers of people to invest.

They officially claim it attracts longer term investors instead of short term speculators. But that’s garbage, because most people in the speculation game aren’t after penny stocks and have large cash reserves.

This is a good place to post my recent thoughts on the stock analysts and fund managers, who have some significant control over the daily market ups and downs: are they really the idiots they appear to be? I know they’re not, but:

How can the stock market go up 300 points in a day on certain news, like a drop in oil, or a favorable earnings report from a big company, and then plummet 300 points the next day on another piece of news? One day, people controlling the market: “YEAH! THINGS ARE GETTING A LOT BETTER! BUY BUY BUY!” The next day “OH NO, WE WERE WRONG, THE SKY IS FALLING, SELL, SELL, SELL!!!” The amount of day to day fluctuation gives the perception these people are incompetent, if they can be so swayed every single day by the news of the day, as opposed to having an opinion based on the overall big picture that is not going to be significantly swayed by one day’s news.

Or it could be these are people who make a lot of money from market fluctuations.

Well, here’s my own newbie question. I don’t understand the problem when the DOW drops 500 points. The media makes comments like “a lot of people lost a lot of money.” They’ll say market value has plummeted. The market is still a buy and sell thing? Someone bought it, someone sold it.

The only way it seems to make sense to me is from a merchantilistic perspective - a DOW/Nasdaq being weak means more money is gonna be flowing into finance types in London and Shanghai as opposed to New York.

In a word, yes.

The total value of the shares is worth less in terms of actual capital, so people who still hold shares have less net worth as they can’t sell the shares at the previous price.

Selling shares also doesn’t mean that there is a buyer. It simply means they are on the market. More shares on the market depresses the value of the stock. If people buy up the shares, then the value could go up again.

There’s no legal minimum that I know of (for common stock - preferred MAY be different). Many companies go years without paying dividends, even when times are good (see below).

The expectation is to make money. It really doesn’t matter whether one makes money from dividends or capital appreciation.

Some profitable companies choose not to pay dividends at all. There can be sound reasons for this - good for both the company and the investors.

Money that otherwise might have been paid out as dividends, the company might choose to reinvest in growing the business. A growing business generally needs plenty of capital. Tech companies in particular have a history (in recent decades) of not paying much in dividends and reinvesting the profits instead. In theory, the investor comes out ahead this way - after a few years, the shares they own now represent a piece of a larger, more profitable company. Of course, it’s possible that things don’t go as planned for the company.

Even companies that DON’T need a lot of extra capital to grow the business (perhaps they are in a stagnant industry) sometimes pay less dividends than they otherwise might. Instead, they use extra funds to buy back shares. The current US tax structure encourages this to an extent. Past structures, and the likely future structure, if Obama is elected, encourage it more.

Essentially, from the point of view of a single investor (call him Joe), there is no real structural difference between the company buying back shares (from investors other than Joe), or paying a dividend, which Joe reinvests in buying more shares. Either way, Joe owns a larger slice of the company. But if the company pays the dividend to Joe, that’s a taxable event, now, for Joe. If the company buys back shares internally, there is no taxable event for Joe. Eventually, when Joe liquidates his holdings (perhaps to pay for college or retirement), he will pay taxes, but that date might be years away, and in the meantime, the money is effectively growing tax-deferred. Moreover, for much of the past, cap gains tax rates (what you pay on the profit from selling shares) have been lower than dividend tax rates. Obama, IIUC, plans to revert things at least partially to that past structure, which will again create a strong incentive for corporations to use extra profits to buy back shares rather than pay dividends.

Again, as an investor, if I buy a share of stock for $100, and it stays flat and I earn $10 in dividends, that’s pretty much the same as if it pays no dividends but rises in price to $110. (Yeah, it’s not exactly the same, because of the tax issues, timing of dividend payments and so on, but it’s close).

If you’re thinking long-term vs. short-term investor, it still doesn’t really matter. If I had bought GE circa 1993, and held it to today (i.e. ~15 years - pretty long term), I would have made money in part based on increase in the share price, but also based on the fairly substantial dividends GE has consistently paid (which, perhaps I might have reinvested). If I had bought Microsoft in the same time frame, I also would have made a lot of money, even though Microsoft didn’t pay any dividends for many years. They grew their business substantially, which also benefits shareholders. Note - I don’t know exactly which company’s shares have done better in that time frame, given dividend reinvestment - I’m just trying to make the point that investors in the long term can make big profits either way. They can also lose money if things go badly. And they can also do all this over much shorter time frames.

A company does not directly benefit when its share price rises. But indirectly, it benefits in many ways. Companies do not do a single IPO then never touch the stock market again for 100 years. Instead, many companies use their own stock as currency in many ways. They do secondary IPOs. They compensate employees and execs with stock or stock options.

And of course, don’t forget that investors buy shares at IPOs (and thereafter) in the hope of profits (be they from dividends or share price appreciation). A corporation is, in theory, run by agents of the shareholders, to benefit the shareholders. If the corporation’s activities (or even dumb luck), cause the share price to increase from $10/share to $15/share, then that’s good for those shareholders. i.e. The distinction between the shareholders and the corporation is not, perhaps, as strong as you might think (from a “who gains when the price goes up” perspective, anyways).

I’ve described a few methods above (where there is a direct benefit to the company). There’s also an indirect way in which stock prices allocate money, market-wide. When a given public company’s stock price does very well, it inspires investors and entrepreneurs to invest in similar companies. Netscape IPO’d in 1995 and the price soared, IIRC. That in turn caught the attention of a lot of folks. Venture Capitalists actively sought out internet companies to fund. Entrepreneurs started new internet companies. Programmers sought out jobs in the internet business, hoping to profit from stock options.

The reverse can also happen. Auto company stocks have, by and large, done poorly for years. Therefore, there have been few companies doing new automobile companies.

Of course, back in the early part of the 20th century, auto companies were the hot industry, sort of like internet companies were in the 90s, and alternative energy companies are today. Ten years from now, some new technology will show promise, shares of companies in that industry will soar, and there will be a rush of talent and capital into the industry.

Splitting shares does not generate capital for the company.

Companies CAN (and do) issue more shares either when they need capital or, perhaps, when they view their share price as overly high and they want to take advantage of it. Not surprisingly, investors view companies that do secondary offerings as sending a signal that perhaps the shares are overvalued, and so share prices normally drop. Still, absent that effect, there’s not necessarily much harm to the existing shareholders. Yes, they are diluted (their shares now represent a smaller percentage of the company), but the company now has more capital, and, in theory, should use that extra capital to more than offset the dilution. Of course, it doesn’t always work out, but it’s not easy to figure out which stocks will succeed and which won’t.

Don’t know if this has been addressed, but the “fundamental return” on a stock (as Bogle puts it) is corporate earnings growth plus dividend rate. Only applies to very long-term investing. This is off the top of my head, but I think corporate earnings growth kind of captures the long-term appreciation of the stock price, which (at least historically, but not so much now) tended to follow a pretty typical stockprice-to-earnings ratio.

Here’s a Bernstein article that somewhat touches on it. http://www.efficientfrontier.com/ef/401/onestep.htm Couldn’t find anything else on Google, I haven’t kept up with my personal finance knowledge. Hope that helps.

They’re not? Well I suppose you could call it willful ignorance instead of idiocy, but if the recent credit crisis made something very clear is that the vast majority of people who used to call themselves “economic experts” are, in fact, those idiots.

How can the stock market go up 300 points in a day on certain news, like a drop in oil, or a favorable earnings report from a big company, and then plummet 300 points the next day on another piece of news?
Faith. The ENTIRE economic system as it exists today is based on faith. Hell, we even use fiat currencies who’s value is completely based on belief in that value alone. Combine this with the trading of stuff where it is hard to determine what the real value is (like say SUBPRIME MORTAGE PACKAGES) the value they will pay is whatever number below they think they can sell it for. Note, that at this point, the real value of a product has become completely irrelevant. Which explains nicely how those billion dollar profit institutes suddenly turned into billion dollar losses institutes.

It’s all hype, if somebody sneezes in the wrong direction every daytrader jumps on because they don’t want to risk “missing the boat”. The only real smart traders are those who invest while taking decades into account, not days.

It’s a model that allows unlimited growth. That also means it allows unlimited decline.

Not unlimited. A small percentage of currency can still be backed by specie. We are still operating under a fractional reserve system even though the currency floats. Any decline (assuming it would even be allowed to last that long) would halt when the money supply is in line with supplies of specie and production.

Banks operate under a fractional reserve basis, but US currency is fiat and non-convertible; it’s not fractional.