If you've made it this far in the Investing Classroom, you can't have escaped the following: A stock represents an ownership in a business. So let's say we are part owners as well as managers of a business, and when we closed the books on the year, our firm made a $10 million profit. Better yet, we collected all of it in cash. Now the rub--what to do with that cash?
Assuming we don't simply leave it in the corporate checkbook (though some companies certainly do), we've got four choices. We could:
- Reinvest it in the business
- Acquire another company
- Pay down debt
- Return the cash to shareholders
Real-life boards of directors face this decision in every quarter of every year. While the first three options can be productive uses for cash, the fourth--a reward to shareholders--is a critical part of the investment process. After all, why else would you want to own a stock if you never received a payback on your investment? Stocks are perpetual-life securities--there's no guaranteed payoff at some maturity date like there is with a bond.
In fact, the grandfather of security valuation (a little-known figure named John Burr Williams) defined a stock's value as the present value of future dividends. It's pretty easy to see why this is true. Even though capital gains loom large in most investors' minds, the ability to sell a stock tomorrow for more than was paid today is contingent on that stock eventually returning cash to its owner, whoever that owner might be at the time.
Dividends: The New Fad? >>