marketsIn the past, the average value of stocks has increased quite consistently at a fairly high rate, and it is expected to do so in the next decades (although perhaps at a lower rate).
My question is the following: What drives the increasing value of stocks in the long run?
My guess is that it is partially explained by inflation and productivity increases (which includes technological improvements, better education, better health and perhaps increasing population).
In the Long Run, ceteris paribus (all other things being the same), a company’s stock can increase in value ONLY if it pays out more Dividends. (Also called the Theory of Dividend Discount Model)
Proof:
Assume:
A planet MOLDOVA somewhere in the space, having some currency = Moldavian Leis MDL.
interest rates are 10%
No risks ( e.i. there are no additional risks in investing in a corportate bond/stock than in a Governmantal (Federal) Bond)
Short term interest rate = medium term = long term interest rate = 10%
If 1 stock pays 100 MDL per year , you would be maximum willing to pay:
Price of Stock = Dividend / Interest Rate = 100 MDL / 10% = 1000 MDL
If, due to economic growth (increases in money supply) and other factors the PROFITS of the company increase in time, it will also increase in the long run the Dividend payments, let’s suppose the dividend increases to 112 MDL per year, now the price is
Price of Stock = Dividend / Interest Rate = 112 MDL / 10% = 1120 MDL
One should also note the role of the interest rates thta is to be substituted with the personal required interest rate, since it is dichotomous (different for every individual), all people will value the same stock differently.
Contrary to what user704 suggested (I would comment on his post, but I don’t have enough reputation), Dividend Discount Model does not work in real life. There are many companies that have not paid a single divident or are not expected to pay dividents in the near future. That’s why there are other models such as Discounted Cash Flow Model, which says that the stock’s price is the discounted sum of all it’s future cash flows. As with the Dividend Discount Model, it has its own disadvantages. One of them is that it uses a constant discount rate, which in real life obviously changes all the time.
In short, I don’t think it’s true to assume that if you buy a share of all publicly traded stocks now, you’ll get more in 50 years. One of the reasons is that not all companies will exist 50 years from now (I believe the term is survivorship bias). The ones that do should cover for the losses you incurred from others that don’t. So, as you said, ignoring inflation, the future value of stocks will increasy because of improvements in efficiency.
The positive trend of stock value is a consequence of the growth of the economy.
In theory the stock value of a company is just the value of its earnings. So as the GDP grows so, on average, the earnings of each company and its stock value.
@6ahodir. Thank you for your valuable input.
The reason why I used DDM is because I want to use a model as simple as possible (but not too simple) with assumptions that will not distortion the concept of the stock pricing. The cash flow model is useful if analyzed in the SHORT-MEDIUM outlook. I think we will both agree that nobody buys a piece of stock from a company and HOLD IT FOREVER if it SURELY knows that it will never bring any profit (revenue-costs). IF you held some stocks that u knew would never bring any profit you would want to sell it rather than hold it because you would expect nobody would want to buy it. This will drive the price of stock to zero. So stockholders of any company must have expectations of some kind of profit (even if it is purely speculative)
Another reason why I used the DDM is because we treated the CONCEPT of price formation in the LONG RUN and this model also ASSUMES the company will still exist. If you knew with a 100% probability that the company will bankrupt in a future point in time before any dividents are paid and if we assume you won’t get any assets left over after giving out debts, thne the stock you hold values 0$ and 0 cents.
The constant inflation of the money supply makes the price of most assets go up over time.
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