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Stocks - Are They Nothing More Than Pieces of Paper?

Aug 17, 2007
Contrary to popular belief, stocks are not just pieces of paper. When you own a portfolio of stocks, you really own tiny fractions of several companies.

If you think that this isn't the case, just ask the lucky owners of Petco or Reebok stocks. In each company's case, a larger company wanted to buy them. The only way to take over a company with publicly traded stocks is to buy all of the shares.

If you had Petco and Reebok stocks at $20 and $35 apiece, would you sell them to a larger company for less than that? Of course not. For $20 and $35? Probably not, since if you wanted those prices, you could have sold your stocks in the open market.

The only way for larger companies to take over smaller ones is to offer a premium to the owners of their stocks. In Petco's case, for example, the stockholders received a 50 percent premium. That means if you had $10,000 worth of Petco stock, the very next day you would have had $15,000. Not bad for a day's work!

Big profits like this can only happen when you take the initiative to start investing in stocks. But if you still think that stocks don't have real value, read on.

What Gives Stocks Their Value?

Stocks go up in value because they are in demand. Stocks go down in value because they're not in demand. This is the simple truth, but a misunderstanding of it leads to the notion that stocks are "just pieces of paper."

Sometimes, stocks have an increased or decreased demand for no good reason. But the root value of stocks can be found in the value of their underlying businesses.

Stocks in Action - Fed Ex

For example, take a look at fairly stable company like Fed Ex (ticker FDX). It had annual profits of $1.8 billion in 2005. Since Fed Ex has 305 million shares of stock outstanding, this equals about $5.90 earnings per share (EPS).

Fed Ex's share price is around $112 per share. This means it's P/E ratio is about 19 (112 / 5.90 = 18.98), which is about the average P/E ratio for stocks in the S&P 500.

When you own a share of Fed Ex, you own a share of its profits. You own a share of the cash in its bank account, and you even own a share of its property, plant, and equipment. In the case of Fed Ex, you own a share of each of its trucks!

Now of course, if you own 100 shares of Fed Ex, that's only 100 shares out of more than 300 million - even a million shares ($112 million worth) would be less than 1/3 of 1 percent of the company! In other words, your one share doesn't entitle you to much decision-making power with what is done with that $5.90.

You might like them to buy more trucks, advertise more, or maybe even send you the check for $5.90 (a dividend). But you're just a little guy, and nobody listens to the little guy. You can, however, vote in shareholder elections to decide the corporation's board of directors.

The owners of stocks oversee the board, the board oversees the CEO, and the CEO oversees the company. That's how owning stocks works.

The Real Value of Stocks - When Stocks Buy Other Stocks

So you can't decide what to do with Fed Ex's $5.90 in profits, because you only have 100 votes out of 305 million (you get one vote per share of stock that you own). But you know who could decide what Fed Ex would do? Someone who owned all 350 million shares.

Let's say that the stock market took a real nose dive for some reason. That can happen. But let's also say that Fed Ex's business kept rolling along, generating profits in the $1.8 billion range like it did in 2005.

How low could the stock go? Imagine the stock went from $112 all the way down to $45. Now its P/E ratio would be 7.6 (45 / 5.90 = 7.6), assuming it continued to generate $5.90 in earnings per share. At this price, the entire Fed Ex company might be an attractive acquisition candidate for someone like UPS.

If UPS bought all 305 million shares of Fed Ex, it could do whatever it wanted with that $5.90 - it would be money in the bank. Better yet, by reducing competition and eliminating some overlapping costs, that $5.90 per share could easily turn into $6.50.

So how much would you sell your $45 share of Fed Ex for? Less than $45? Of course not. You'd be surprised, but UPS might be willing to offer as much as $65, if it thought it could get Fed Ex's profits up to $6.50 (thereby recovering their investment in ten years).

Now you might be saying, "Hey, wait. I bought the stock at $112 and I'm supposed to be happy I can sell it for $65?" That's not the point. The point is that stocks do have real value. If you're a conservative investor, you want to buy stocks that are already beaten down and could potentially become acquisition candidates.

Just the possibility that someone could acquire an entire company keeps stocks from falling too low. And that's what makes stocks more than just pieces of paper.
About the Author
William Smith the author provides much more financial information on many subjects as well as the secret to his success in the market along with 5 Free power stock picks emailed daily so grab your Free subscription on his website at Stock Picks (All is Free)
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