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Stocks: How to Pay Someone Else to Work for You

 When you work for a company, you work to build someone else’s wealth.  When you own a company, other people work to build your wealth.

Fortunately, you don’t have to be Bill Gates or Elon Musk to own a profitable company.  Instead, as we touched on briefly in the article on assets vs. liabilities, you can buy stock in the company.  Buying a share of stock mean you actually own a small piece of a company.

One of the most efficient ways to own stocks is by purchasing low-cost index funds.  These funds can either be in the form of mutual funds or Exchange Traded Funds (ETFs).  The key difference to a traditional actively managed fund is that the index fund simply tracks the relevant market.  For example, an S&P 500 index fund would hold shares of the largest 500 U.S. companiesIn the S&P 500’s case, the largest 500 with some consistent caveats: at least 10% must be publicly available for trade and the last 4 quarters must have shown a profit..  This means there are no active decisions, so the only trades that need to made can be automated and computer controlled. This cuts out the bulk of management costs and these funds tend to have expense ratiosNet expense ratios are charged as a percentage of the assets each year. less than 0.1%, all the way down to 0%, compared to a traditional fund at 1-2%.

Apple Inc. Headquarters in Cupertino, CA

Apple's Hedquarters in Cupertino.  Apple currently has the largest market capitalization and so makes up the largest of many small pieces of US equity index funds.  Therefore, when you own an index fund, you own a small fraction of the productivity of every worker in this building.

In future articles we will explore why these fees make such a big difference and how simply tracking the index actually generates significantly higher than “average” returns.  Ideal funds track an index like the S&P 500 or Total Market with a net Expense Ratio as low as possible, 0.05% or lower.  Owning shares of these funds means you own a small piece of hundreds of companies with millions of workers, all toiling away to put money in your pocket.

Popular Index Funds (Click to Sort) - Updated April 2021

Ticker Index Expense Ratio Type Provider
ITOT Broad Market 0.03% ETF Blackrock
IVV Large Cap 0.03% ETF Blackrock
FXAIX Large Cap 0.015% Mutual Fund Fidelity
FZROX Broad Market 0% Mutual Fund Fidelity
FNILX Large Cap 0% Mutual Fund Fidelity
SCHB Broad Market 0.03% ETF Schwab
SWPPX Large Cap 0.02% Mutual Fund Schwab
SWTSK Broad Market 0.03% Mutual Fund Schwab
SPY Large Cap 0.0945% ETF SPDR
VTI Broad Market 0.03% ETF Vanguard
VTSAX Broad Market 0.04% Mutual Fund Vanguard
VFIAX Large Cap 0.04% Mutual Fund Vanguard
VOO Large Cap 0.03% ETF Vanguard

The funds in the table above are examples that either track a US large capitalization index like the S&P 500 or a broader index from 1,000 to 3,000+ US stocks.  Since the funds are market capitalization weighted, and the expenses are low, performance has been extremely similar between all the funds in the list.  Many of the funds are available on different brokerage platforms, but some may charge trading fees for a competing provider's fund.

Where do shares of stock come from?

When a company is first started, it is owned by its founders.  Most business require money to purchase things like machinery and raw materials and pay for labor before they can create a product or service that will drive their revenue.

Sometimes the founders can directly supply this capital.  Sometimes they are able to take a loan from a bank.  Often, however, the amount of capital required exceeds what the founders can supply and a start up business is too risky a proposition for most banks.  In this case the founders will look for outside fundingYou may have heard terms like Private Equity or Angel Investors and typically exchange it for partial ownership (equity) in the company.  This form of private ownership is typically very restricted and illiquid, meaning it is difficult or even forbidden to sell the equity position.

If the business is successful, it will continue to grow.  Eventually it may require additional funding, or the original private investors may be ready to get paid back and exit their position.  At this point the company can have an Initial Public Offering (IPO).  In an IPO, shares of the company are listed on a stock exchange and sold for the first time.

Executives ring the bell on the New York Stock Exchange to celebrate the Initital Public Offering of their company.

The company receives an amount of money equal to the opening price multiplied by the number of shares they issue.  After this, those shares are now owned by the public.  When shares are subsequently traded, it is between two third parties.  In other words, when you buy a share of stock on the market, you buy it from another investor, not the original company, so the company receives no money from you.

How do stocks make money?

A successful company has two basic decisions to make with its profits: reinvest them or pay them out to the owners.  Reinvesting the profits is only valuable in so far as that it will eventually lead to even more future profits to pay out to the owners.  Companies early in their life or in high growth markets often choose to reinvest.

As the companies start to generate more cash than then can productively reinvest, they start to return that money to shareholders.  The two main ways to do this are with dividends or share repurchasing.

When a company decides to pay a dividend, they pay out a set amount of cash per share.  For example, if ABC Co. has 10 million outstanding sharesThe total number of shares that can be traded. and has $5 million of cash they want to return to investors, they would issue a dividend of 50 cents per share.  Each stockholder would receive $0.50 for every share that they own.

$$ {$5,000,000 \over 10,000,000\ shares} = {$0.50 \over share}$$

Share repurchasing, also known as a stock buyback, is when the company itself buys shares from the open market.  These shares are then added to the company treasury.  This removes them from the outstanding shares and these shares no longer receive dividends, since the company would just be paying itself.  The result is that the value of the company is divided over less shares, so the value per share should rise accordingly.

Let's say ABC Co. has a market capitalizationThe total value of the company, also equal to the outstanding shares * price/share of $80 million, so the price per share would be $8.

$$ {Market\ Capitalization \over Outstanding\ Shares} = Share Price$$ $$ {$80,000,000 \over 10,000,000\ shares} = {$8.00 \over share}$$

This time, instead of paying out the $5 million cash in the form of a dividend, they instead decide to fund a share repurchasing program and buy back 625,000 total shares.

$$ {$5,000,000 \over $8.00 / share} = 625,000\ shares $$

This by itself doesn’t change the $80 million valuation of the company, so after the buy back with less shares outstanding, each share is worth proportionally more.

$$ {$80,000,000 \over 10,000,000\ shares - 625,000\ shares} = {$80,000,000 \over 9,375,000\ shares} = {$8.53 \over share}$$

Stock Prices

Ultimately, however, shares of stock are valued by investors for their future expected dividends.  In an efficient marketA market where all the players know all the relevant information and can trade freely.  Most large public equities in regulated markets approach this ideal., any investment is valued as the net present valueNet present value discounts payments in the future, as money today is worth more than the same money tomorrow.  This has the effect of bringing the total of a potentially infinite stream of payments to a limit as the present value of far future payments dwindle. of all future pay outsA stock that was guaranteed to never pay a dividend would be worthless by definition..  For a stock, these payouts are the dividends promised to that share.

Reinvestment of profits in the company serve to increase future profits while share buybacks increase the proportion of those profits that can be paid out to each remaining share respectively.  Both methods are trading a dividend payout today for the hope of increased payouts in the future.

Since these payouts are projected far into the future, a small change in sentiment about the prospects of a company could have a large impact on the pricing by changing the calculated net present value.  This is why the price of any individual company can look volatile over a short period: if good news comes out today, they may be making a lot more sales and profit not only this year but every year in the future.  Likewise, bad news may portend decreased profits fat into the future, and the compounded effect is significant.

These swings tend to be more pronounced with companies early in their life cycle with unknown futuresImagine a small pharmaceutical company, with wild price swings on positive and negative news about its single potential drug line. but less so as companies mature and show a stable history of dividend payouts.  Despite the short-term fluctuations, over time a productive company that creates a profit and pays out dividends will drive value both by those payments and the price of stock rising in proportion to the increase in the dividends.  Furthermore, holding a diverse portfolio of stocks, as with an index fund, serves to further dampen price fluctuations as the temporary fortunes of many different companies offset each other. In this way, buying stocks and holding for the long term is a great way to add assets to you balance sheet.

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