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# Easy Question About the Article: The Social Function of Stock Speculators

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liberation posted on Sun, Nov 18 2012 7:53 PM

Indeed, one standard definition of the "correct" stock price for a company is the present discounted value of its future dividend payments.

Can you give me an easy to understand example for this? Like examples from Investopedia, they have easy to understand definitions with easy examples.

Thanks!

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Smiling Dave replied on Sun, Nov 18 2012 9:03 PM

The correct price is, as a first approximation, how much money it will make you. We assume the stock represents a business, and it makes you money by profits. In other words, we are ignoring the fact that maybe it will jump in price for some reason or other.

So how does it make you money? By giving you dividends. If we assume the company will last fifty years before collapsing, and each year pays \$10 in dividends per share, then each share should be worth 50 years times ten dollars per year, which equals 500 bucks.

That's the first approximation. However, we have to modify this because of the famous principle of bird in the hand is worth two in the bush. In other words, the ten dollars I will only get fifty years from now is not worth the same to me as getting ten dollars right now. Same thing, though not as acutely, for the ten dollars that I have to wait a year for.

So that each year's dividend, when determining the value of the stock to me, has to be discounted, meaning counted for less than the face value of ten dollars. Next years ten bucks might only be worth \$9.25 to me, and the ten dollars of year fifty, being so far away, might only be worth, say \$4.73.

Add up all the discounted values, \$9.25 +...[insert discounted values of the other forty eight years here] +\$4.73, and you get the "correct" value of the stock [to me, with my sense of values for money to be gotten later] by that definition.

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It's easy to refute an argument if you first misrepresent it. William Keizer

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Andris Birkmanis replied on Mon, Nov 19 2012 4:18 AM

We assume the stock represents a business, and it makes you money by profits.

But the profits may be reinvested without being payed out as dividends. I am not sure why you are so opposed to the idea of capital gains.

Oh, and there is no need to assume the company will ever collapse - because of the time discount, even perpetual flow of income has finite present value.

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Smiling Dave replied on Mon, Nov 19 2012 5:48 AM

Andris,

You are quite right in both points. My aim was to give a simplified scenario, the better to clarify the key concepts.

My humble blog

It's easy to refute an argument if you first misrepresent it. William Keizer

• | Post Points: 20
907 Posts
Points 14,780
Andris Birkmanis replied on Mon, Nov 19 2012 8:04 AM

Glad we are on the same page :)