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So now they're tying the value of a stock certificate to the company's performance. And that's certainly the way it mostly seems to work in real life. But why?


Here is my understanding of this. One way to see a company, or a business, is a "black box" that converts inputs into cash. The inputs are primarily people and "capital". In a more general sense, the inputs are "capital" and "operating expenses", and people fit into the "operating expenses" category along with utilitiy bills, pencils, etc.

Take a look at the "capital" input. In this model, capital refers to the fixed assets that are required to make the product or service that the company produces. If your company is going to create CPUs, then you're going to need a very expensive factory in which to create them.

The key, however, is that all of this exists to create a product that can be sold for a higher cost than its inputs. In other words, this whole enterprise (hopefully) creates a net surplus of cash. In my mind I am thinking of a black box with a big crank. As you turn the crank, money spits out. First, we need to build the black box itself, then we need to turn the crank. Building the black box is investing capital, and turning the crank is spending operating expenses.

A company can raise capital by selling part of itself in a public offering. Usually, companies do this to raise capital to build the first incarnation of their black box.

As the company hums along, generating cash, there are a couple of things it can do with this excess cash. It can either pay that cash out to the owners of the company (this is what a dividend is), or it can reinvest the cash in the business to make the black box larger and more efficient at producing cash.

You can see Return on Invested Capital, which Warren Buffett says is a primary consideration in evaluating a business, is so important. This is a measure of how much cash the black box generates compared to the cost of building it in the first place. A box that costs $5 to build and produces $0.25 per month is better than a box that costs $25 to build that produces the same $0.25 per month. That's return on captial: how efficient is the business?

So you can start to see the "black box" as something that has some real value! It is a creation that generates wealth by creating products and services of value.

As the company generates cash (income), if it chooses to reinvest the cash into the business and does so wisely, it can make itself more and more valuable. In my model, the company is choosing to invest the cash that comes out of the black box in creating a better and better black box. Or, the company might purchase a second or third black box (acquisitions, or expansions into other markets).

Imagine you bought 1% of a company when it just started out. They were raising capital to build their black box. It turns out they built a very good one and they were able to generate a lot of cash. The company kept investing the cash it created into expanding and improving the black box. In other words, it made its black box more efficient at producing cash, and thus more valuable. It should be clear, then, why your 1% ownership of the company should increase in value.

The stock exchange is fundamentally about people exchaging their shares of ownership in companies based on whether they believe the money they are being offered for their shares today is a better deal than the increase in value of the company over time.

From a theoretical point of view, a stock *should* be worth the net present value of all of its future net cash flow. In other words, it is worth the sum total of all cash the black box will ever generate, but expressed in today's dollars. Think about it. If you had an actual black box with an actual crank that could make money, what would you sell it for? A fair price would be all of the money it could produce in its lifetime, adjusted for today's dollars. (Actually, you would need to subtract the cost of someone turning on the crank, which is why I use the term future *net* cash flow -- net of the cost to turn the crank).

It is unknowable exactly how long or how effectively any particular black box will perform. That means it is unknowable what the price of the business *should* be, because that involves knowing what the sum of all future cash flows will be. And *that* is why it appears to be gambling.

In fact, it *is* a form of gambling. However, like poker, chance is not the only element involved. People are trading things that have *actual* value -- fractional ownership of a black box that is generating cash.

In cases like the "dot com bubble", what is happening is that people are buying shares of a (now) unprofitable company because they believe that the black box the company is building, when they finally get it built, is going to generate a tremendous amount of cash. That is a *prediction*, there is no way to know this exactly, just like there is no way to know if 5th street is going to bring you the flush card to give you a winning poker hand.

You can see the consequences of this: it is possible to profit off of people's mistaken impressions. And so the market mechanism itself becomes a source of "profit" totally independent of the black boxes generating cash. This aspect is indeed a zero-sum game. But underlying all of it is businesses that are creating things, creating wealth.

Jim