Why shares are like second hand cars

One of the most persistent myths of the financial industry is that the shares traded on the stock exchange somehow indicate the ‘value’ of the company that issued them. In reality, the reverse is true. Company shares have virtually no connection with the company that issued them and have little or no effect on the company, its trading or its performance.

This highly counter-intuitive statement is so at odds with the received wisdom that hardly anyone dares to believe it, even when the real facts are explained to them. But I’m going to have just one last try at explaining anyway.  🙂

Joe Soap invents a better mousetrap. He holds the patent and it’s a sure fire winner, but Joe has no money to manufacture, sell and distribute the product to the shops. So he forms a limited company and issues 100 shares at £1 each on the stock exchange. He keeps 51 shares for himself because he doesn’t want to lose control of his company, and sells 49 shares on the stock market.

He now has his working capital in the bank – £49 – and uses it to set up his factory, make mousetraps and sell them. What Joe has done here is to borrow £49 from members of the public, offering as security for the loan a little bit (one hundredth) of the equity in his business per share.

He also promises that, once his company makes a profit, he will reward the investors’ faith in him by paying dividends – compensation for the interest they would have earned had they invested in something safe like fixed-interest government stocks.

The important point to notice here is that the shareholder does not become a creditor of Joe’s company. Buying a “share” in Joe’s firm doesn’t entitle him to anything other than the piece of paper he receives. If the company goes into liquidation, shareholders get nothing.

Joe offering “shares” in his company is not the same as Joe offering his house as collateral for a bank loan, because the shareholders are not creditors of Joe’s company and have no right to Joe’s assets. They have simply bought a piece of property – the “share” – which they now own and are entitled to use as they wish, to sell, to use as collateral or any other purpose for which property can be used.

The investment by shareholders is a straight gamble. If Joe’s company is a success, they will be able to sell their shares again for more than they paid. If his company flops, they won’t be able to sell the shares and they’ll have lost their money. The market value of their shares depend on Joe’s success or failure.

Similarly, the dividends they received will depend on Joe’s success or failure and the investor is gambling that the dividends they get from Joe will be more than they could have got from a safer investment.

The idea that the shares reflect the “value” of the company comes about because if all 100 shares were sold, the company would have assets in the bank of £100. But this value is purely notional. In reality Joe has no assets other than his idea for a better mousetrap and if the company fails there will be nothing in the bank.

The company is only “valued” at £100 at the very beginning when Joe still has the cash in the bank. Once he’s spent it, he may have no assets. (Note also, Joe didn’t sell all the shares because he didn’t want to lose control, so in fact the most his company is ever worth is £49 in cash.)

Here’s the really, really important point that’s so difficult to take on board. Once Joe has sold a share and received £1, he no longer owns that share, or has any say in what happens to it. If the new owner sells it for £2, Joe gets nothing. If the new owner sells it for £0.50 pence, Joe loses nothing. Nothing that ever happens to that share ever again, can directly affect Joe or his company that issued it.

The stock market is a place where people buy and sell second-hand shares. It’s like a used car lot, or an antique auction room. No matter how many Volkswagens or Fords are sold from the used car lot, neither Volkswagen nor Ford ever see another penny. No matter how many Picassos are sold at auction, the artist never sees another penny.

Now, it’s quite true that share prices can have an effect on the company that issued them indirectly in a number of important ways. They include:-

Employees of the company may be paid partly or wholly in shares: if share prices go down, they lose.

The company may be thinking of going to the market to raise more capital with another share issue: if the market price of the last issue falls, people may be put off buying and the new share issue may fail to raise the capital needed for expansion.

Analysts and tipsters advise investors on which shares to buy: if a company performs poorly they will advise against investing in it again. If a company performs well and has a healthy balance sheet, they may advise for investing.

In the event of a hostile takeover bid, the company will be obliged to buy back its own shares from the market and this will force the share price up.

Once Joe Soap has been in business successfully for a year or two, and submitted proper accounts, he will have premises, machinery, contracts with shops, and intellectual property that can be valued for sale. If he has been successful in business, then this asset value of the company will be greater than the amount of working capital he raised initially – perhaps many times greater. His order book and annual profits will also contribute to a healthy valuation.

It is this value that is often confused with share value. The shares (which, remember, are no longer owned by the company and have no connection with the company other than any dividends it may pay to shareholders) are valued purely by market forces in the marketplace in which they are bought and sold.

It’s true that market analysts will offer advice to buy the shares of a company as being a sound investment based partly on the company’s actual asset value. It’s also true that the higher the asset value of the company then, in general, the higher the price at which its shares will trade. But all this share trading will take place in isolation and is not connected to the company asset value directly.

Of course, the market value of shares in Joe’s company will closely reflect the market value of Joe’s company – because eagle-eyed stock market analysts and buyers know a successful company when they see it and will start to buy shares on the expectation of a further rise in market value.

But – and this is the important point – this close correlation of Joe’s company’s asset value, and the value of his company’s shares as traded on the exchange is an illusion. It arises because both values spring from the same foundations. But the two values are not and can never be linked together as cause and effect.

As a result, the stock market sometimes gets things spectacularly wrong and values shares high when the company is in reality in big trouble.

This is the explanation of the apparently bizarre fact that in 1990, IBM was the world highest capitalised company and one of the world’s most profitable companies with earnings of more than $6 billion while two years later, 1992, it made the biggest corporate loss in history, losing nearly $5 billion.

So that when, as recently happened, The Telegraph ran this story:-

“Glencore shares obliterated after analysts warn they could be worthless. The stock collapsed by 30pc in afternoon trading, wiping more than £2bn off the value of the company.”

This story is meaningless twaddle. The £2 billion was “wiped off” the value of the second-hand shares in Glencore being traded on the stock exchange. The effect on the value of the company was zero.

It is perfectly true that the shareholders collectively own the company and can get together at the AGM to force through changes in management and to vote down measures of which they disapprove. But none of this directly alters the asset value of the company – though in the long terms such changes might well be beneficial.

The bottom line: aggregate value of company shares is one thing. Company asset value is quite another. They are not directly linked. Telegraph sub-editors please stop writing silly headlines.

Leave a Reply

Your email address will not be published. Required fields are marked *

Top