I’m currently reading David Stockman’s book and he states that the fundamental purpose of the stock market is to discount future corporate profits. What exactly does it mean to discount future profits and what purpose does this serve in terms of allocating resources efficiently. I’ve been asked what the purpose of stocks are and it is easy to explain why they are issued initially, but difficult to explain the purpose of trading, especially when most people only see today’s highly speculative and volatile culture.
Stock markets allocate capital funding by increasing or decreasing the asset values of a company. Investors buy a company’s stock on the basis of their anticipations of the future net worth of the company. If they think the net worth will rise, then the buy the stock which bids up its price today. Because the company itself is the largest shareholder, its share holding increase in value. But its shareholdings are an asset on its balance sheets. Therefore, its net worth rises today providing the opportunity for the company to take on larger liabilities today. In other words, it can borrow funds today.
he same thing happens in all asset markets. If homeowners bid the price of houses up in my town, then the price of my house rises. This creates equity in my house, which I can borrow against.
A share of common stock is an ownership claim on a portion of a company’s net worth. If a company has $100 million of net worth with 1 million shares of stock, then each share has a claim on $100. There are two main factors in increasing net worth. One is acquiring assets with greater value than the liabilities incurred to acquire them. The other is earning net income.
If investors anticipate an increase in future earning of net income, then they will pay more for the stock toady. But they will not pay $1,000 today to acquire $1,000 of earnings in the future. Because of time preferences, they will pay only a price today discounted according by the rate of interest which is the inter-temporal price of money. If an investor can earn $1,100 at the end of one year by investing and the rate of interest is 10 percent, he will only pay $1,000 today to acquire these earnings.