WHAT'S IT WORTH?
The value of an antique car is set by the highest bidder; a single person who is willing to pay way more than anybody else. You never know who will show up at the auction! Cars, boats, and Bitcoins are worth whatever a buyer is willing to pay.
This is also true of stock prices, but it’s terribly misleading. If you believe that there’s no fundamental value to stocks you’ll start looking for magic in chart patterns or black boxes, and you’ll worry that prices can go to zero. They say that rising stocks continue to rise, but wouldn’t that suck up all the money in the world?
So let’s start with bank CDs. You know what they’re worth, because the FDIC guarantees that you’ll get your money back; and the Fed’s power to print money stands behind the FDIC. The only catch is that the interest rates on CDs are barely above the inflation rate. They’re not a long-term plan for retirement savings. And the same can be said about gold, which should give you a return that’s similar to the inflation rate because the metal is rare. Cryptocurrencies aren’t rare, so the long-term returns should be much lower …
The government’s power to print money also stands behind U.S Treasury bonds. Now we’re getting somewhere, because bond yields are higher than CD rates, and higher than inflation. That “real” return is usually less than a percentage point, if you’re buying 10-year treasury bonds. When interest rates are rising those bond returns drop below zero.
Bonds are debt; you lend money to the government or to a corporation. Shares of common stocks, on the other hand, represent ownership of a corporation, so the growth of your investment should be similar to the growth of the corporation. And corporations (all of them, together) grow about as fast as the economy.
Here’s where we unveil the big secret. That growth isn’t the 2% or 3% GDP growth that you read about in news reports, because that’s an inflation-adjusted number. Corporate revenues, or sales, grow at the “nominal” GDP growth rate, which is twice as fast. It averaged 6.2% over the last 70 years.
Corporate earnings grow faster than corporate revenues, because they use part of their earnings to invest in growth initiatives that are meant to benefit the shareholders. Some of that is used to buy back shares; if they buy back half the shares, your piece of the company will be twice as big, so your earnings per share will double! That should cause the stock price to double.
You also have to add in your cash dividends, which grow every year. With moderate growth and inflation the theoretical return on common stocks is above 7%. The actual returns of the last few decades, with higher inflation and growth, and declining interest rates, exceeded 9% a year.
Of course, panic can send stock prices far below reasonable values. And euphoria, on some far future day, will push stocks to unsustainable heights.