You ask some excellent questions. Unfortunately, completely answering them would take hours, but I'll try to give a summary. Where to start...
Question 1: 'Why should company management care about the stock price?'
Answer: You raise the point that, unless they plan to issue additional stock, there is seemingly no incentive for company management to care about the stock price.
This is a well known problem in political science and economics. It fact, it has a name - the "principal-agent problem". The principal, the shareholders, and the agent, the management, have conflicts of interest.
There a millions of ways for company management to legally steal money from their shareholders. The hope is that by giving company management ownership, through stock options or some other mechanism, it will align their interests with the shareholders. Whether this is usually the case, well, you decide... but typically company management owns meaningful amounts of the stock.
Question 2 (strongly related to Question 1): 'How do stocks have intrinsic value if what only matters is what you can sell it for on a secondary market?'
Answer: Good question. The answer is easy if the stock issues most of its profits through dividends (think Altria Group), but as you noticed is much more difficult if the stock - like most - does not. I used to often wonder about this....but there is an answer.
As a shareholder, you are the owner of a company. Thus, you are entitled to a portion of the company's earnings... (no matter what the secondary market says).
You've probably heard of the PE ratio - Price/Earnings per share. But what you may not of heard of is the much more meaningful inverse - the Earnings Yield (Earnings per share/Price). For instance, a stock with a PE of 10 has an earnings yield of 10% ($10 dollars buys you a $1 per year return).
Low PE = High Earnings Yield; so PE of 10 = 10% Earnings Yield
So, if you own a stock with a PE ratio of 10, you are getting a 10% return on your capital. Now, it is up to company management to decide what to do with that return. They basically have two options:
1. Give the return back to the shareholders through a dividend.
Let's say that a company has a PE of 10 and thus an earnings yield of 10%. If the company were to distribute all of the profits back to the shareholders, it would have a dividend yield of 10%.
OR
2. Reinvested the return back into the company, so that the future earnings yield will be bigger.
You invest money to get a big return on your invested capital (ROIC) to compensate you for the risk you are bearing. If the company can earn a bigger return on capital for a given amount of risk than the shareholders can elsewhere, it should reinvest it back into the company.
For instance, if the company can build a factory for $1,000,000 that earns $350,000 per year, then the return on capital is 35%. (I'm oversimplifying for the sake of argument.) Now...I don't know about you....but a 35% return is pretty damn amazing. I would rather have the company management take my earnings and reinvest it at 35% than give it back as a dividend, because I doubt I could earn 35% on my own.
So, if the company takes my 10% return and reinvests it at 35%, then the next earnings yield will be 13.5%. If the secondary market still values the company at a PE of 10, a 10% earning yield, then the stock price will have to go up 35% to adjust for the increased earnings.
Of course, the secondary market may not immediately react by driving up the share price 35%. The market can do whatever it pleases, but the company still has an intrinsic value because you are entitled to a portion of its earnings.
Now at it turns out, over the long run, the market is an excellent judge of intrinsic value... which brings us to the next point.
Question 3:"How Do Markets Work?"
This is the answer I gave a Game Theory professor at my college:
Answer: The goal of money managers is to get the highest return for a given level of risk. Typically, they are evaluated on how well they "beat the market". By "beating the market", we mean outperforming the market averages. Typically the market average is measured by a popular index, like the S&P 500 or the Dow.
To put it another way, managers are evaluated on their ability to outperform the other managers. That is what "beating the market" really means.
Now, by definition, not everyone can beat the market....by definition not everyone can be better than average. After all, it is the cumulative bets by all the players, including the money managers, that IS the market. Since they ARE the market, they can't all beat the market. As a group, they will get the market return minus the costs to play the game.
Now, people pay mutual fund managers on average 1.5% per year for "professional" investment expertise. They pay them to pick stocks that will 'beat the market'. As I already stated, not all of them can beat the market. However, over the lifetime of the investor that 1.5% fee will eat up about half of their nest egg. To the advantage of mutual fund companies, people don't realize this.
In fact, over long periods of time (10 years or more), 90% of mutual funds underperform the market. They typically underperform by the amount of the management fee (1.5% per year on average) and the other costs incurred. Those that do beat the market do not exhibit performance persistence. Thus, from empirical evidence, stock picking is a loser's game. The skill of the money manager does not seem to affect returns. By trying to be better than average, 90% of them do worse than average after cost.
The only way to win is not to play...to NOT try and beat the market averages. The cost of playing the game is too expensive. The solution is to invest in what is known as an index fund. An index fund is a mutual fund that simply copies a market index like the S&P 500. By copying the index, it is basically copying the aggregate bets of all of the other players. Since you are not paying a manager to try and outsmart everyone, most good index funds have management fees of about 0.20%. By simply doing nothing and copying the market average at the lowest cost, you do better than 90% of professionals.
I'm not sure if this constitutes a Nash Equilibrium...but given that all the players are trying to beat the market, your best response is to copy everyone else's bet at the lowest cost. Wall Street depends on people trying to beat the market, despite the predicted futility of doing so. Basically, buying and holding the entire market is the best response to whatever the market does.
Now, financial theory actually predicts this outcome. This is because markets are assumed to be efficient. By efficient, I mean they discount all known-information. The current share price is the best possible estimate of the stock's real intrinsic value (its future cash flows discounted back to the present). This is what is known as the "Efficient Market Hypothesis". If markets are efficient, then your expected return is determined by risk and luck. It is impossible to "beat the market", it predicts, other than by assuming more risk or by luck. Essentially, return comes from risk. The job of an investor is to assume risk in exchange for return. Skill has nothing to do with it, despite the advertisements of mutual fund companies.
Warren Buffett is actually betting a group of hedge funds managers $1,000,000 that they will underperform the market average over 10 years after cost. The irony, of course, is that Buffett has actually outperformed the market average over 40 years or so. He is considered the 10-sigma anomaly by finance professors. However, what most people don't realize is that most of his success comes from business management and buying entire businesses, not stock picking.
http://money.cnn.com/2008/06/04/news...tune/index.htm
You can learn more about investment and index funds at the Head-Fi of investment:
Bogleheads Investing Advice and Info
Bogleheads :: View topic - Investment Planning
