Making Sense

John Lim

I SUGGESTED a thought experiment in my last blog post—one in which the stock market shut down for six months at the start of the pandemic. I believe it helps explain why financial markets recovered with such a vengeance.

Today, I take a different tack, one based on financial theory. It’s easy to forget that stocks are not pieces of paper (remember stock certificates?) or ticker symbols on a computer screen. Rather, they represent a claim on company profits, though only after bond and preferred stock investors get their due. These claims are perpetual, meaning they continue indefinitely or so long as the company remains a going concern.

In theory, the value of any company, and hence its stock, is the sum of its expected future dividends, discounted to the present. Don’t get hung up on the term “discounted.” It just refers to the fact that a dollar received in five years is worth less than a dollar received next year.

Imagine a dividend-paying company that’s able to increase its profits, and hence its dividends, by 5% a year over the long run. By adding up its discounted dividends—let’s say over the next five decades—we can arrive at an estimate of the company’s intrinsic value, which should be reflected in its stock price.

What happens to the company’s intrinsic value when we assume next year’s profits and dividends disappear because of, say, a global pandemic and economic shutdown? The answer is that it falls by just 3.1%, assuming a 7% discount rate. If the next two years of dividends are cut, intrinsic value falls by 6.1%.

In early 2020, the S&P 500 fell 34% in the span of a few weeks thanks to the fears brought on by the pandemic. Using our admittedly simplistic model of intrinsic value, a 34% drop in stock prices implied that the next 12 years of dividends were going to be axed. Did that really make sense? As investors recovered from their initial shock, stock markets staged a massive comeback. To many onlookers, the resurgence made little sense. But when viewed through the lens of what stocks actually represent—a claim on future dividends—it made total sense. What didn’t make sense was the initial market collapse.

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