Critical of growth stocks, similarities to fiat money?

[MindsEye]

I am new to the investing world and I am learning about how things work. And I am thinking the concept of stocks over. I am making statements but they are more like questions in my mind than statements.

As a shareholder you would 'normally' be payed a dividend equal to the percentage of the profits that is equal to the percentage of the business that you own represented by your stocks.

Now, what about stocks that don't pay a dividend or stocks that don't pay out all the profits as a dividend. They use the money for growth or something else. I am being a little critical about a stock that doesn't pay out the profits in dividends now and will not appear to in the future either for these reasons:

1. It would appear easier to write a number on the bottom line when you don't have to pay out dividends to stockholders. I would think it would be easier to use 'tricky' accounting practices to make it look like the corporation is bringing in more profit than it really is without having to back it up by paying out dividends. For example, as I understand it offering stock options to management or employees can make it look like the expenses are less than they really are.

2. When there is no dividend being payed out I would think you are more dependent on what other people are willing to pay for that stock to make a profit. If you were making a good sized dividend, it wouldn't matter as much if the price of the stock fell if the profits and dividends didn't fall. You would still be making the same amount of money in dividends. In a stock that doesn't pay out all the profit in dividends, you have to sell relative to what other people are willing to for that share in the company as determined by the market to make a profit.

3. Also I am curious about how a stock has value if a corporation never pays out a dividend over the entire life of the stock and than goes out of business. It almost feels like fiat money to me where it doesn't have intrinsic value, the value is derived because of other people's confidence that has value.

[c1ue]

Re: Critical of growth stocks, similarities to fiat money?

As a shareholder you would 'normally' be payed a dividend equal to the percentage of the profits that is equal to the percentage of the business that you own represented by your stocks.

Dividends should not be assumed to be a 'normal' behavior for a company. It is true that in the past a company would return money not needed for investment to shareholders.

However, today many companies choose not to go that route, but rather to either accumulate cash or buy back stock.

1. It would appear easier to write a number on the bottom line when you don't have to pay out dividends to stockholders. I would think it would be easier to use 'tricky' accounting practices to make it look like the corporation is bringing in more profit than it really is without having to back it up by paying out dividends. For example, as I understand it offering stock options to management or employees can make it look like the expenses are less than they really are.

Note that one reason 'tech' companies would issue options was that they would receive a tax benefit equal to the stock price (at exercise time) minus option grant price, once the option was exercised. Many companies such as Cisco, Dell, Microsoft, Apple, etc have done this in the past resulting in tax bills proportionately much lower. Retaining cash in turn thus permits a reinforcing cycle where bought back shares = higher stock price = higher tax benefits from options exercises.

Classical economics would normally dictate a lower stock price due to dilution, but as you can see there are corporate self serving ancillary benefits besides the 'employee motivation factor'.

2. When there is no dividend being payed out I would think you are more dependent on what other people are willing to pay for that stock to make a profit. If you were making a good sized dividend, it wouldn't matter as much if the price of the stock fell if the profits and dividends didn't fall. You would still be making the same amount of money in dividends. In a stock that doesn't pay out all the profit in dividends, you have to sell relative to what other people are willing to for that share in the company as determined by the market to make a profit.

This assumes that the company stock price dropping is not due to a competitiveness/economic reason which would also affect the company's earnings. Obviously lower company earnings would make paying a dividend more difficult.

3. Also I am curious about how a stock has value if a corporation never pays out a dividend over the entire life of the stock and than goes out of business. It almost feels like fiat money to me where it doesn't have intrinsic value, the value is derived because of other people's confidence that has value.

Keep in mind that if a company liquidates - either bankruptcy or some other reason, there are still physical assets. Cash, buildings, inventory, intellectual property, etc are all potentially still worth something. The stock value - theoretically its book value - is intended to represent this.

Of course book value in growth sectors is extremely hard to determine as another pernicious tax practice comes into play: Goodwill.

I am simplifying, but when a tech company is bought, the difference between its physical assets and its purchase price can be accepted by the purchaser as goodwill. This goodwill can be accumulated and used to partially offset taxes as well.

Needless to say, this also reinforces the stock options/share buyback/tax gain loop.

[DemonD]

Re: Critical of growth stocks, similarities to fiat money?

Minds, this is probably the wrong place to ask about the theoretical technicalities of stock valuation. (itulip is great for a lot of general macroeconomic type things, and buying an individual stock is much more micro economic in nature.) But basically when you buy stock in a company, you are becoming a part-owner of that company. Which means you have a part ownership of the buildings, the cars, the infrastructure, the supply lines, the contracts, the cash, the debt. Generally it's a very small part, but a part nonetheless.

1. It would appear easier to write a number on the bottom line when you don't have to pay out dividends to stockholders. I would think it would be easier to use 'tricky' accounting practices to make it look like the corporation is bringing in more profit than it really is without having to back it up by paying out dividends. For example, as I understand it offering stock options to management or employees can make it look like the expenses are less than they really are.

One of the few things that frustrates me is when EJ talks down Sarbanes-Oxley. You are right, companies can do this, and some have done this very much in the past. But also realize there are a lot of "shareholder-friendly" companies that overly dilute their shares.

And also realize in the past 5 years it has gotten much more difficult for companies to get away with this behavior. Sarbanes-Oxley has put an almost total kibosh on "cooking the books" so to speak. CEO's can now go to jail for signing onto fraudulent quarterly earnings reports and misleading statements. New Century Finance has something like a dozen lawsuits already against it for fudging their numbers after their announcements last week. Further congressional rules have made it so that stock option expenses must be expensed as part of their earnings report. A misreporting of options expenses is against federal law and is actionable.

As much as I respect EJ and his good work, the one thing that confuses me is why he is so against SOX. SOX is a GOOD thing for all retail investors, for transparency, for truthfulness, for confidence in the markets.

2. When there is no dividend being payed out I would think you are more dependent on what other people are willing to pay for that stock to make a profit. If you were making a good sized dividend, it wouldn't matter as much if the price of the stock fell if the profits and dividends didn't fall. You would still be making the same amount of money in dividends. In a stock that doesn't pay out all the profit in dividends, you have to sell relative to what other people are willing to for that share in the company as determined by the market to make a profit.

Dividends put a floor under most stocks. But you must be careful about dividends and their yields. The ability to pay a dividend is more important than the dividend itself. A lot of subprime mortgage lenders pay nice dividends... think that will continue this year?

3. Also I am curious about how a stock has value if a corporation never pays out a dividend over the entire life of the stock and than goes out of business. It almost feels like fiat money to me where it doesn't have intrinsic value, the value is derived because of other people's confidence that has value.

A stock has value because of the physical value of the holdings of the company as described well by c1ue. It has further valuation if it is making money and paying a dividend. It has further valuation if it holds certain intellectual properties which can be monetized (like medications, automotive blueprints, the manuscript for Lord of the Rings, etc.) And finally it has further valuations on the expectations of investors that the company will be making more money in the future. This is basically a very small run through of stock valuation.

here is the wiki for stock valuation: http://en.wikipedia.org/wiki/Stock_valuation

Remember Google is your friend when you have questions like how is a stock valued.

DemonD has positions in the following companies mentioned above: Google

[EJ]

Re: Critical of growth stocks, similarities to fiat money?

As much as I respect EJ and his good work, the one thing that confuses me is why he is so against SOX. SOX is a GOOD thing for all retail investors, for transparency, for truthfulness, for confidence in the markets.

You're contradicting yourself. First you tell mindseye that itulip isn't a good place to go for stock valuation info and then you proceed to give him a very cogent answer to his or her question.

On my dislike for SOX, remember that my perspective is as one who served as CEO of private companies, on the boards of over a dozen private companies, and gets a earful from CEOs of public companies all the time. SOX added exactly zero to truthfulness and transparency of public companies. All SOX adds in overhead. One of the reasons more companies are not going public is that SOX overhead raised the minimum cost of legal and accounting compliance from a couple of hundred grand to well over $1MM, so many companies now can't afford to. Further, board members are now held personally responsible for things that go on in a company they can't possibly know about or control, with liabilities not fully covered by DNO insurance, the result of no-nothing bureaucrats setting the rules, which hammers the risk/reward ratio for participating on boards. Several of the guys that were on my boards won't do board seats any more for that reason. And these are really, really high quality guys. Their exit is a real loss for my industry.

How effective is all this regulation? Note that all of the stock option back-dating scandals have come out after SOX has been around for more than five years.

All the rules ever needed already existed. SOX is pure politics. It's real purpose is clear if you look at the "jobs" section of the SOX web site.

All that was needed after the scandals on the tech bubble era were, as I was saying during that bubble, enforcement of existing laws to prevent them from happening in the first place. But as long as the capital gains tax money rolled in, the SEC didn't enforce the rules. During the housing bubble, lenders were allowed by regulators to run a-muck, intimidating appraisers into inflated appraisals, for example, and telling borrowers to lie on loan applications to qualify for a loan, a felony in some states. I noted these events during both bubbles.

All that is needed to prevent abuses is for existing laws to be enforces. A few bad apples need to 1) get prison time and 2) not be allowed to keep their money when they get out. Today, even if these criminals do get prison time, a lot of them get to keep millions when they get out. As this is a society that respects anyone with money, no matter how criminally it was made, these guys quickly re-invent themselves and go right back into circulation. Right now we have a "crime pays" system, so it shouldn't surprise anyone that there's a lot of fraud, and adding more regulation doesn't help. Also, expect that after each bubble, frauds will be "discovered" by regulators, always conveniently after all the potential asset bubble cap gains taxes have been collected. Then redundant regulation will be enacted after the fact designed to provide employment for friends of the politicians who failed to enforce the existing laws in the first place. Watch for a re-run shortly in hedge funds. In fact, you can already see them getting set up in the press, to wit, the Barron's article about hedge funds last week.

So tell me, how is SOX good for retail investors?

[Spartacus]

how is SOX good for retail investors?

So tell me, how is SOX good for retail investors?

"sell the sizzle, not the steak"

the markets are NOT safer because of SOX, but the public thinks that because of SOX, they are safer.

to the stock salesmen and politicians and boiler-room operations, public perception is all that matters

Public thinks there's no problem?
Cool (thinks the politician) - problem gone.

[DemonD]

Re: Critical of growth stocks, similarities to fiat money?

You're contradicting yourself. First you tell mindseye that itulip isn't a good place to go for stock valuation info and then you proceed to give him a very cogent answer to his or her question.

Eric, if I sounded abrupt I didn't mean to. itulip provides a service that is very valuable for many people with open minds and currency to invest. I do not come here for specific talk about stocks and the stock market - there are many other great sites for that. That doesn't mean I'm going to ignore his question. I enjoy typing and writing and using my brain. I can talk about stocks all day and night, but what I generally do here is learn things outside the box of what I normally read for fundamental analysis. Basically what I'm saying is "itulip's not the ideal place to discuss the specificity of the stock market, but here is a real general rundown of how I see it."

So tell me, how is SOX good for retail investors?

This question is too large for me to answer in a quick post. I will do some research and write out an essay on a new thread on why I believe SOX is good for retail investors.

I do understand where you are coming from though Eric and I look forward to further exploring this matter.

[renewable]

Re: Critical of growth stocks, similarities to fiat money?

MindsEye, Berkshire Hathaway is a growth stock that doesn't (yet) pay dividends. Read somewhere a while ago that Buffet said it possibly would if he ever ran out of viable investment opportunities.

SOX is great for the UK - Together with (IMO) lax regulation & taxes, London has had a great deal of floatations recently. Not so good for the US.

[grapejelly]

Re: Critical of growth stocks, similarities to fiat money?

Fiat money is not backed by anything. But many enterprises are properly reinvesting earnings instead of harvesting them, so growth stocks are backed by something.

And many investors put their money in a stock so as to get a capital gain and don't want the dividend as they believe the company has a higher ROI than they can get by investing the dividend somewhere else.

Dividends are an admission that the firm lacks internal investment opportunities for the money.

[jk]

Re: Critical of growth stocks, similarities to fiat money?

Fiat money is not backed by anything. But many enterprises are properly reinvesting earnings instead of harvesting them, so growth stocks are backed by something.

And many investors put their money in a stock so as to get a capital gain and don't want the dividend as they believe the company has a higher ROI than they can get by investing the dividend somewhere else.

Dividends are an admission that the firm lacks internal investment opportunities for the money.

on the other hand, those "internal investment opportunities" may include empire building via unwise and expensive acquisitions or expansions. many companies have been buying back stock because they don't know what to do with their cash. [that and to offset the dilution of their options plans.] the preference for capital gains is an artifact of our tax system and the double taxation of dividends. similarly the preference for leverage is encouraged by our screwed up tax system.

[Finster]

Re: Critical of growth stocks, similarities to fiat money?

I am new to the investing world and I am learning about how things work. And I am thinking the concept of stocks over. I am making statements but they are more like questions in my mind than statements.

As a shareholder you would 'normally' be payed a dividend equal to the percentage of the profits that is equal to the percentage of the business that you own represented by your stocks.

Now, what about stocks that don't pay a dividend or stocks that don't pay out all the profits as a dividend. They use the money for growth or something else. I am being a little critical about a stock that doesn't pay out the profits in dividends now and will not appear to in the future either for these reasons:

1. It would appear easier to write a number on the bottom line when you don't have to pay out dividends to stockholders. I would think it would be easier to use 'tricky' accounting practices to make it look like the corporation is bringing in more profit than it really is without having to back it up by paying out dividends. For example, as I understand it offering stock options to management or employees can make it look like the expenses are less than they really are.

2. When there is no dividend being payed out I would think you are more dependent on what other people are willing to pay for that stock to make a profit. If you were making a good sized dividend, it wouldn't matter as much if the price of the stock fell if the profits and dividends didn't fall. You would still be making the same amount of money in dividends. In a stock that doesn't pay out all the profit in dividends, you have to sell relative to what other people are willing to for that share in the company as determined by the market to make a profit.

3. Also I am curious about how a stock has value if a corporation never pays out a dividend over the entire life of the stock and than goes out of business. It almost feels like fiat money to me where it doesn't have intrinsic value, the value is derived because of other people's confidence that has value.

Your skepticism is healthy, MindsEye.

In answer to 3 above, the residual value should be paid to shareholders at liquidation. But if you look at the earnings reported by many corporations, a lot of it just never makes it to the shareholder either via dividends or addition to shareholder equity. Shareholders need to look carefully at both dividends and corporate balance sheets. If it doesn't either get paid out in dividends or accrue to equity per share, it's meaningless to shareholders.

That second part is a little tricky because due to accounting arcana, it's not at all straightforward to figure out what shareholder's equity is. But for the most part you can see whether it has increased from one year to the next by comparing successive balance sheets. Add together the addition to equity per share and dividends per share paid out, and you have a number against which to compare earnings. As alluded to before, very often the total is quite a bit less than reported earnings.

[c1ue]

Re: Critical of growth stocks, similarities to fiat money?

MindsEye, Berkshire Hathaway is a growth stock that doesn't (yet) pay dividends. Read somewhere a while ago that Buffet said it possibly would if he ever ran out of viable investment opportunities.

That, and a lot of their cash comes from the insurance float!

[DemonD]

Re: Critical of growth stocks, similarities to fiat money?

Dividends are an admission that the firm lacks internal investment opportunities for the money.

I do not agree with this statement at all. A special one-time dividend (like what microsoft did in late 2005) may indicate this. But a recurring dividend is generally part of a company's shareholder and company policy to reward it's owners for taking the risk of owning stock in the company. It's the board of directors, who are (in theory) supposed to represent stock shareholders, that decide on dividend distributions. Regular dividends can demonstrate strength in the internal cash flow of the company, and dividends also can be seen as a motivating factor for high-level executives - if you're a company that is a dividend achiever (a company who has raised their dividend for 25 straight years and has not missed a distribution), and you are a high-level exec you probably have a lot of stock in the company, so a dividend is an extra bonus for you.

Also, Berkshire Hathaway is an anomaly because it has the best CEO arguably that ever existed. Usually cash that could be put towards dividends ends up being squandered. Also, Buffett's corporation is completely unique; he can buy an israeli steel company, you won't see wal mart or johnson and johnson doing that.

[grapejelly]

Re: Critical of growth stocks, similarities to fiat money?

But a recurring dividend is generally part of a company's shareholder and company policy to reward it's owners for taking the risk of owning stock in the company.

Dividends are fine for companies that are not in growth markets. But for true growth companies I will stand by my statement.

dividends also can be seen as a motivating factor for high-level executives - if you're a company that is a dividend achiever (a company who has raised their dividend for 25 straight years and has not missed a distribution), and you are a high-level exec you probably have a lot of stock in the company, so a dividend is an extra bonus for you.

dividends are not deductible in the US so they are a poor way to distribute funds to managers.