When you own a stock, what do you really own?
Shares of stock represent ownership in a company. As an owner, albeit a small one, you have a claim on the future cash flows of that company. Since those cash flows will come in over a long period of time into the future, you have to discount those to today in order to determine their present worth. That simple mathematical formula is the “worth” of the share of stock.
Compare that to the price of a stock and you will often see neither rhyme nor reason. But regardless of this, what you own does not change. A company’s future cash flows do not change because its stock price changes. The more you pay for a share of stock, the lower your rate of return will be given the same future cash flows. That’s why it matters what you pay for stocks.
(Paul Montgomery was famous for noting that if stock valuations were so coldly mathematical, you would never have markets with buyers and sellers because everyone would agree on the “correct” price. The fact is that understanding the price of stocks demands that you go beyond the rational math into the irrational. What “should” happen is often not what actually happens.)
When we read headlines that trillions of wealth evaporated during the August market downturn (CNN), it’s easy to forget to keep your eye on future cash flows, not today’s price. Aggregate wealth is not determined by the last trade price of the publically traded stocks! That implies all the owners of stocks could go somewhere and “redeem” their shares for that price, when in fact if all the owners tried to sell, prices would plummet.
Keep “wealth” and “value” separate, and remember that the total value of the stock market at any given time often includes the irrational influences.