I just don’t understand how it works…when I hold shares in a company and I spend money there, am I technically making a very very small amount of that money back?
ALSO:
what is the simplest way to explain how stock prices increase then?
In: Economics
To explain in the simplest way, the stock prices aren’t directly related to how much a company earns. They’re just a guess about what you (i.e. the market) think the company and it’s stock are worth. Basically, people buy stock in a company, not specifically because stock has any utility or because they want to grow the company, but because they see the potential to make a profit by selling the stock at a higher price later down the road, and maybe make a little extra through dividends.
A stock is essentially a type of currency. When you buy a stock for, let’s say, $10, you buy it with the intention to sell it later to someone else for $12 or $14 or $100, and that person who buys it from you is doing so expecting to sell it for an even higher value down the road. If you know there’s someone out there in the world who’ll buy the stock for $14, then that’s what the stock is worth. Because that’s all you can do with a stock once you have it – you either sell it at its current price to someone who expects its price to increase in the future, or you hold on to it hoping that its price increases in the future when you’ll then sell it.
Where company profits come in is about *confidence*. When people see a company that’s making a profit, it’s generally an indicator that the company has stable finances and isn’t going anywhere. As this *confidence* and *trust* in the company increases, people become more confident that the stock price will increase, and so that confidence ends up increasing the price.
This confidence in the stock is normally maintained by the company in two key ways – through stock buybacks, as well as dividends.
A stock buyback is basically the company giving a guarantee that it’ll buy back stock at a certain price, and that helps stabilise or raise the value of the stock to that price. In this case, the company’s profits are important because these profits are the main source of the funds used for the stock buyback. Hence, if you see a company making a good profit, you become confident that they can afford to buy back their shares, and so the company becomes the person you sell your shares to.
The other main method of stabilising and growing the stock price is through dividends. A dividend is a constant monthly or yearly payment made by the company to every person that owns the stock. Since you earn money on a stock through dividends even without selling the stock, they’re seen as a steady source of income for these stockholders, and so they’re willing to pay more and more money to buy these stock until the point where the return on investment from the dividend is almost negligible. The source of the money for paying these dividends obviously comes from the company’s profits, so higher profits tend to increase confidence that the dividends will keep coming, and so increases the stock price.
It’s worth noting that it’s entirely possible for a stock’s price to drop even though the company is making a profit. This is often seen in unstable markets, where even though a company may have made record profits recently, traders are not confident that they’ll continue to earn that same amount in the future, and so the price can crash. Inversely, you can have a company that’s losing money year after year, but whose stock price keeps increasing constantly – because investors see the company’s losses as a temporary period and expect the company’s value to skyrocket in the future.
As such, I want to stress again – the stock price is *not* correlated to the company’s profits. It’s related to confidence in the company. Especially for a company that doesn’t offer regular buybacks or dividends, the stock price is dependent on how confident you are that you can find a bigger fool to take the stock off your hands, someone who values it more than you do.
As a final note, I was mentioning that stock is inherently useless, and its main value lies in how much you expect to sell it for later. However, that’s only true for the common trader that holds small amounts of stock. For larger traders that hold significant amounts of a company’s stock, they become shareholders that have a say in the main decisions and management of the company.
Latest Answers