The Prof G Pod with Scott Galloway - Prof G Markets: What is a Stock?

Episode Date: January 9, 2023

This week on Prof G Markets, we’re starting the year by getting down to the basics and answering a foundational question: what is a stock? Scott shares the story of his first-ever investment as a 13-year-old, and offers his thoughts on how to value a stock. Learn more about your ad choices. Visit podcastchoices.com/adchoices

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NMLS 1617539. This week's number, 24%. That's the percentage of stocks traded by retail investors in early 2021. The historical average is 10 to 15%. Speaking of retail, I saw my doctor this morning and complained that I was bleeding from my and he totally ignored me and kept pushing his cart down the Walmart aisle. That's good. That's good. That's good.

Welcome to the first Prop G Markets episode of 2023. We pre-recorded it, so there's a decent likelihood we've been canceled by now. But anyways, our mission at Prop G Markets is to educate you about the markets to help you achieve economic security. And more often than not, when we talk about the markets, we mean the stock market. To begin the new year, we're going to get down to the basics. What is a stock? But first, Ed, happy new year. Happy new year, Scott.

Yep, we're kicking off 2023 with a special episode. But before we get into what stock actually is, Scott, you have a great story about the very first time you bought stock when you were 13 years old. Could you tell us about that? So my mom's boyfriend, Terry, told me he used to stay with us on weekends. And as he was waiting for his cab, the cab came honked and he slammed down $200 to $100 bills, which I'd never seen before, and said, go buy some stock. Because I was asking him a bunch of questions about stocks. And I took the $200.

And after school, I went into Westwood Village where I lived and I went to Merrill Lynch. And I remember him saying, go to one of those fancy brokerages. And I had noticed them on the RTD 83 bus, which I used to take to school down Wilshire Boulevard. I went into Merrill Lynch, Pierce, Fenner, and Smith, and I sat in the lobby. And as a 13-year-old, understandably, I didn't get a lot of attention. And I became very self-conscious. So I left and I walked across the street to Dean Witter something, something, and something. And this woman came up and said, how can I help you? And I said, I have $200 to invest.

And I showed the $200 to her and she immediately put them in an envelope and said, wait right here. And then this guy with a big kind of mane of frizzy black hair came up to me and said, welcome to Dean Witter. And I said, I have $200. I want to buy stocks. And he said, that's great. First, let's talk about stocks. And he said, he kind of took me through a lesson about supply

and demand when people like a company because it has good news or the market is up that there's more buyers than sellers. So sellers have the power to increase prices. And he kind of took me through a quick market lesson. And we zeroed in on a stock. He said, you should buy a company that you understand. And I said, well, I like movies. So we bought, I think, 14 shares of Columbia Pictures that was trading around 15 bucks a share. And from that point on, about once a week, I used to walk into Westwood Village and he'd always make time for me and sit down with me and give me another lesson on the markets. But every day, literally every day during recess, I would go to the phone booth, the pay phone booth in the middle of the field of Emerson Junior High School in Westwood. And I would call Cy,

and he would always take my call. And he would talk to me about movements in the stock price of Columbia Pictures. And he'd try and attach a story to it. Close Encounters of the Third Kind is a hit, and the stock moved up today. Casey's Shadow is a bomb, and the stock moved down. Or the overall market is moving down, or the overall market is moving down and most people are selling stocks, not buying stocks. And we developed a nice rapport. And I know this comes as a surprise, but I didn't have a lot of friends at the age of 13. And this was a nice anchor for me. And it was a nice relationship with a man who just took a vested interest in my wellbeing. And in addition to it being about a nice man

who took an interest in the son of a single mother, he used to call my mom and say nice things about me. This has paid off for me enormously because I have sold companies for a lot of money. But the reason I am as economically secure as I am is that I've always invested in the markets. And I feel as if I understand the markets better than your average bear.

I hold on to investments for a long time. I diversify. I try and understand the companies I'm investing in. And my economic security is a function of the markets. Yeah, we love that story because it's really the origin story of not just this podcast, but also Scott's entire professional project. It all started with owning a few shares of stock. So we want to dig into this very basic question. What is stock? What did Scott actually buy

40 years ago? Here to help us answer that is Prof G Media's editor-in-chief, Jason Stavis. Ed, at the most basic level, stock is ownership, but it's a particular kind of ownership. It's one that allows for the ownership of an organization rather than a thing, and ownership of that organization by many people at the same time. It's part of a system that we've developed over the centuries to finance and manage large-scale private enterprise. So for most of human history, private enterprise was small-scale. Think family farms, blacksmiths, and cobblers. Anything more ambitious, like a military campaign or a road network, was usually the domain

of governments or sometimes religious institutions. But in the 19th century, with the rise of industrial production, private enterprise needed more scale. The cost of building and outfitting factories was beyond the means of most individuals. So ambitious entrepreneurs needed a way to pool their resources. That's more complicated than it sounds, however. Joint ownership raises all sorts of thorny questions. If the enterprise is profitable, how do we divide up the profits? If it loses money, who's responsible for funding it?

What happens if one of the partners dies or wants to get out of the business? Who's responsible to the employees and customers if there's a problem, like a fire at the factory or a faulty product? And then crucially, who's in charge? So over time, what has evolved to resolve these challenges is the modern corporation. A corporation, it's a legal construct. It has no physical existence. It's not a building or a group of people, but it has legal personhood. It can own property, it can enter into contracts, it can borrow money or lend it, it can sue, it can be sued, and it has to pay taxes.

Now, it's not entirely the same as a person. Corporations can't vote, for example, and they can't marry or take custody of a child. But for nearly anything a business needs, the corporation can take the place of an individual business owner. Now, one of the most important features of a corporation is what's known as limited liability. There's a lot of risk in business, and a corporation can find itself over its head in debt, or worse, it can be liable to someone for injuries or losses because a product failed. Fundamental to the concept of corporation is that the corporation itself is liable for debts that it incurs, but not the owners themselves. So if you own a stock in a corporation that makes cars and its

cars explode or fail to break properly, an injured driver's sue, they can collect from the corporation or more likely from the corporation's insurance company, but not from you, the stockholder. Similarly, if the company runs out of money, you're not obligated to invest any more money in that corporation. You can if you want to, if you think the business will turn around, it's worth more investment, but you're also free to just walk away. So it sounds like before the existence of corporations and limited liability, if you wanted to start a business or invest in a business, you were also putting all of your personal assets

at risk, which means if the business failed, then your creditors might take your house or your farm or whatever it is. So do you think it's fair to say that the purpose of the corporate form is to encourage more risk-taking in business? It certainly does allow for more risk, so yes. But corporations actually do a lot more than that, right? They allow for large groups of people to share in the economic risk, good and bad, and then manage these complex private enterprises. And stock is the tool we use to do that. It's through stock that these difficult problems of joint ownership are resolved. Each share of stock gives the holder specific, concrete rights over the corporation. And these rights fall into two categories, economic rights and rights of control. So let's talk about the

economic rights first. Stockholders are the ultimate owners of the corporation. Now, that doesn't mean particularized ownership of the underlying assets. When 13-year-old Scott bought those shares of Columbia Pictures, that didn't give him the right to go down to the studio and take home a movie camera or his own copy of Close Encounters. You can think of a corporation as a container.

Whatever buildings or equipment it owns, the cash in its bank accounts, all of that is inside the container. The stockholders, they own the container and its contents, but they don't generally have direct access to what's inside, with two exceptions. So first, in the event the company goes out of business or it's sold, the stockholders have what's known as the residual claim on the remaining assets. Once the company's debt is paid, taxes are paid, anything that's left over in the company's accounts is distributed to the stockholders. Now, if a company goes out of business because it's bankrupt, the stockholders probably won't get anything at all. But if a company is sold, the proceeds to the stockholders can be quite substantial. Now, the second way you can get inside that container

is that stockholders typically share in the profits of a company through dividends. If a corporation makes a profit, that cash is still inside the container. And at least initially, most corporations use their profits to grow the business. They invest in new technology, they hire more people, etc. But eventually, a successful corporation has more profits than it can productively use. So it will start to return the excess to its shareholders. It typically does this through a dividend. A dividend is a fixed payment on a regular schedule. For now, the key point is that being a stock owner means you are an actual owner of the corporation and all of its

assets, including the profits. And your share of ownership is determined by how many shares of stock you own. If a company has 1,000 shares outstanding and you own 100, you own 10% of the company. In the event of a sale, you get 10% of the residual value. And if there are dividends, you get 10% of those as well. Yeah, it's so interesting because I feel like when we talk about stock, especially among my generation, we describe it as this sort of imaginary illusion of ownership in a company. Like it's not actually real. It's just this idea. We often liken crypto tokens to stock because the argument is that you're buying ownership into a project or maybe a brand, something abstract in the future, but you're not actually

buying anything tangible. And what you're saying is actually, no, stock gives you real ownership over real things, equipment, assets, cash flows, etc. And then the other thing you mentioned is that it gives you ownership over decision-making or rights of control. And that also seems quite real. Can you elaborate on that? Yeah. That's the second kind of right that's granted by stock ownership, the right to control the company. With large public company stocks, we don't always think about this aspect of stock ownership because your ownership is such a small piece of a much larger pool.

But it really is fundamental to the corporate system and it does play an important role in how companies are managed. So thinking back again to 13-year-old Scott and his Columbia Pictures stock, just like that stock didn't give him the right to pick up a free copy of Close Encounters, he likewise couldn't walk onto the set

and fire Steven Spielberg for going $15 million over budget. But also as with economic rights, he did have, along with all the other shareholders, ultimate authority over the corporation. Stockholders exercise their authority over the corporation primarily through the board of directors, but sometimes they have a direct vote. The specifics of who gets to decide what and when the stockholders get to vote are typically laid out in the company's bylaws, which is the core document that defines the relationship

of stockholders to the company that they own. In practice, the most important responsibility of the board is to hire and sometimes fire the CEO. But the board also gets directly involved in major corporate initiatives like large acquisitions or big shifts in strategy, or if the company's facing a crisis. Certain major events do require the involvement of stockholders, such as if the company's going to be sold. And stockholders vote based on the number of shares they hold. So that's why in a

large company, an individual shareholder has little discernible influence over corporate activities. But in aggregate, all the stockholders together control the company. In private companies, where there are typically fewer stockholders and each holds a larger share, there's often more direct contact between stockholders, the board, and management. In fact, a lot of times, those are all the same people. But for public companies, there are just a few large shareholders whose preferences really matter. Sometimes these are the founders who've retained a large stake. And often at more mature companies, these are what's known as institutional investors, investment firms such as mutual fund companies and hedge funds. These investors pool the capital of many smaller investors, and so they end up buying really large stakes,

often 5% or 10% or more of public companies. So if I buy Google stock through a brokerage, say Charles Schwab, does that mean I'm handing over my voting rights to Charles Schwab and they'll sort of represent me in those decision-making processes? In what you've just described, no. The vote follows the ownership. Schwab and they'll sort of represent me in those decision-making processes? In what you've just described, no. The vote follows the ownership. So if you bought the stock, even though it was through a broker, and a broker could be Schwab, it could be Robinhood, whoever, you are the stockholder and you get to vote. Now, in the old days, the company actually mailed you a thick envelope a few months before the annual meeting, and it had a ballot and

various other materials in it. So it was really obvious when it showed up in your mailbox. Now, though, it's all electronic, and so it's really easy to miss that email that says, click here for your voting materials. What's different is if you own shares through a mutual fund. In that case, you don't own the stock yourself. The mutual fund company does, and they get to vote the shares. And that's why large mutual fund companies have so much influence over public corporations. Now, that said, at public companies, most investors, even these really big ones, are passive. They believe in the board and they believe in management and the company strategy. That's why they bought the stock in the first place. Now, there is, however, a category of owner known as an activist investor. That's someone who's

using their ownership stake to try and force change at the company. In good times, activists are usually asking companies to distribute a greater share of their profits through dividends. In bad times, activists are more likely to be demanding cost-cutting and cutbacks. Yeah. So, Scott, how meaningful are these voting rights? Can shareholders really change the direction of a corporation? Sure they can. So, when Carl Icahn buys a lot of shares in Apple and begins kind of heckling from the cheap seats, sometimes the easiest thing to do is just to throw a bone at an activist and either put them on your board or do a share buyback or a special dividend, which Tim Cook did. He did a special dividend. A lot of it depends on whether

it's a dual-class shareholder company or not. So when I went on the board of Gateway, it's because I bought 18% of the company. And with 18% of the company, if I ran a proxy fight, which is sort of modeled after an election, about 80% of votes will show up at the annual meeting, meaning if you get 40%, you win. And when I say win, you get to elect your slate of directors who determine the CEO and strategy. And so if you get about 20% of a company's shares, that usually means you're in striking distance of cleaning up the whole board. But theoretically, at least, the owners who are the shareholders should have control over the company. Now, what happens is over time is that companies will come up with reasons that they have dual

class shareholder structures, or they basically hold the wolves at the door. So corporate governance has taken on sort of a Kremlin-like feel. And that is even if you put your money at risk, you don't have the control that's commensurate with your risk. This is where I believe things come off the track. For example, Mark Zuckerberg can continue to make bad decisions because he controls the company. Adam Neumann can hold the company hostage

because he had dual-class shareholder structure. So corporate governance matters and shareholders do have an impact and can have influence, but it's situational. Okay, so we've learned a lot about stock, but we still haven't answered the trillion dollar question. And that is, how does all of this affect the price of a stock? We'll be discussing that after the break. Thank you. What differentiates their investment approach? What learnings have shifted their career trajectories? And how do they find their next great idea?

Invest 30 minutes in an episode today. Subscribe wherever you get your podcasts. Published by Capital Client Group, Inc. Hello, I'm Esther Perel, psychotherapist and host of the podcast, Where Should We Begin? Which delves into the multiple layers of relationships, mostly romantic. But in this special series, I focus on our relationships with our colleagues, business partners and managers. Listen in as I talk to co-workers facing their own challenges with one another

and get the real work done. Tune into Housework, a special series from Where Should We Begin, sponsored by Klaviyo. We're back with ProfitG Markets. So Jason, we've spent this episode discussing things that I don't really think about that much. I own stock, but I've never voted on a corporate decision. I rarely think about dividends. And I don't really picture my stock as a stake in the actual assets of a business. To me, owning stock feels more like a bet on whether the price will go up or down in

the future. And I'm mostly just thinking, how much can I eventually sell this for? So to what extent do these economic rights and these rights of control that we discussed, to what extent do they dictate the price of a stock? Because truthfully, that's all I really care about. That's a surprisingly complex question. And academics and stock market professionals have been studying it for years. And there are a lot of elaborate theories and complex models designed to try to figure out the link between all of what's actually happening at the company

and what that stock gives you and what the stock is trading for on the market that day. I think the best explanation though is a quote from an early 20th century stock market analyst named Benjamin Graham. and what the stock is trading for on the market that day. I think the best explanation, though, is a quote from an early 20th century stock market analyst named Benjamin Graham. And Graham liked to say, in the short run, the market is a voting machine, but in the long run, it is a weighing machine. So to unpack that, let's take them in reverse order. A share of stock is a share of ownership, right? It's a legal claim on the assets of a business, including its future profits, and the rights

influence how those assets are managed. Those two sets of rights give the share its value, or as Graham would put it, its weight. The most important factor in that weight are those future profits. Because what's the point of investing in the company or buying its stock if it won't be making you any money? Now, it's not enough, though, just to say a stock has value. We need to know how much value. And there are two standard approaches to this, the hard way and the easy way. In the hard way, analysts build spreadsheets that project out a company's future cash flows based on what they know about the market, what management is telling them, competition, that sort of thing.

And then you literally add up all those cash flows. So next year's profit plus the following year's profit plus profit the year after that, and so on. The sum of all those profits is the value of the stock. That's how much money the company is going to generate for its stockholders. Only there's a wrinkle because potential future profits are not as valuable as money in your pocket today for a variety of reasons, but mainly because you can't spend or invest them yet and because they're risky. They may never materialize. So when investors add up those future

profits, the further into the future they get, the more they discount them, that is, reduce them by some percentage. This method of projecting future cash flows and then discounting them is known sensibly enough as a discounted cash flow bot, or DCF. Analysts at investment banks and hedge funds spend a lot of time building and tweaking their DCFs. In fact, that's what I did in my first job after college, and I worked very late into the night fine-tuning my Excel spreadsheets. Fortunately, though, there's actually an easier way.

The easy way is what's called a multiple. You pick a number from the company's financial statements, and then you multiply that by some fixed number, and voila, that's the value of the company. The most familiar of these multiples is PE, or price to earnings ratio. That's simply the multiple of the company's value to its profit. But you can also calculate a revenue multiple, a gross margin multiple. In some industries, analysts look at the multiple of the company's assets, which is called a book-to-value ratio.

Subscription-based companies are often valued on a per-subscriber multiple. Any metric that measures the company's weight, to use Graham's term, can be used for a multiple. The multiple is just a proxy for profit growth. A company with a 20x price to earnings multiple is one we expect to grow its future profits faster than a company with a 5x price to earnings ratio. When valuing a company and therefore valuing its stock, analysts pick a multiple based on what similar companies are trading for in the market or what they've sold for in private transactions. So multiples are a lot less complicated than DCFs, but they're still a powerful tool, especially for comparing the value of similar companies. Okay, so now one last point.

I focused on the economic rights of the stockholder because those are the main factors in valuation, but control rights really do matter. A company is more valuable to somebody who has more control over it. As a small public stockholder with little practical control, you shouldn't be willing to pay as much per share as someone who will own a majority of the company.

Analysts refer to this as a control premium. And it's one of the reasons that when a public company is taken over, the price is almost always higher, sometimes a lot higher than the public trading prices. That's why buying stock in a company you think is going to get taken over can be a pretty lucrative strategy if you time it right. Okay, so that was a lot. But the bottom line is that the value of a company's stock, its weight in Graham's term, is mainly a function of how much profit that company is going to generate in the future. Because that's what stock is. It's

ownership of those future profits. But then there's the short term, right? And I think that's what you're talking about, Ed, when you talk about the price of the stock, right? How much is this stock going to sell for right now in the market? In the short run, Graham pointed out, the market is a voting machine. The actual price you get is a function of what people in the market are willing to pay. Like any other asset, stocks trade based on supply and demand. Now, most buyers and sellers of stock, they're evaluating what they want to pay based on those DCFs and those multiples. But they don't all agree on the specifics, right? So the analyst at Fidelity might discount a certain company's future profits by 30%.

But the analyst down the street at Goldman Sachs, she thinks that company's a little riskier, so she discounts those profits by 35%. As a result of that difference, the F fidelity analyst will be willing to pay a bit more for the stock. And when you multiply that across the entire market, you have all of these people voting by purchasing or choosing not to purchase stock at a certain price. Then there are the buyers who aren't voting based on DCFs and multiples at all. Scott bought Columbia Pictures because he liked the movies.

I've owned Apple stock for 25 years because I was introduced to computers by my family's Apple IIe. So the price of a stock on any given day is the product of all these votes and people buying and selling stock for all these reasons. Your decision to buy a stock should be, in large part, an evaluation of whether you think the voting is in line with the weighing. Okay, so let's summarize. First,

stock is ownership. It's a legally enforceable claim over a company's assets and the right to control the company. Second, stock allows us to finance and manage corporations, which is too risky and too expensive for an individual to deal with alone. And third, the value of a stock is the value of its claim to a company's future profits, but the price is ultimately just whatever someone else is willing to pay.

Ed, that's exactly right. I find this distinction between the price of a stock and its actual underlying value so fascinating because it just feels so counterintuitive. Scott, how do you think about this when you're making your own investment decisions? I'll use one of my stocks. I invested in Lemonade,

which is this kind of new economy, really interesting high-end PS insurance company that writes apartment insurance policies. And the stock went public at, I believe, 28 and ran up to, I believe, $180. Now at 180, because of the excitement about the concept of bringing AI in a new, more progressive field to the insurance industry and the size of that market, that there were people willing to buy shares at $180 a share. Looking at the valuation on any traditional metric, even for the fastest growing insurance companies, the valuation just did not

match the price. The music did not match the words. So the opportunity or the cautionary tale is you should always keep an eye on traditional valuation. You should look at fundamentals and say, okay, this is the sector. This is sort of the band that most of the companies trade at in terms of traditional metrics, price to earnings, enterprise value to revenue, enterprise value to EBITDA. They're traditional metrics. And once a company gets way out of bounds, out of that band, either to the high end or the low end, begin thinking, well, okay, if the price is much different than the value, the underlying value or the range of the value, should I leap into action, either sell the stock or buy the stock? And to be

clear, I didn't sell lemonade at 180. I sold it at 50 and 60 and maybe a little at 80. And I'm still sitting on a position when I think it's at 17 or 18 now. So it's easy to say it's hard to do because when the stock hits 150, it feels like this company is going to revolutionize the insurance industry and you stay there. But it's always important to recognize there is a difference between the price and the valuation. And the price doesn't dictate the underlying valuation. You should do that in isolation of what the price and the valuation. And the price doesn't dictate the underlying valuation. You should do that in isolation of what the price is because the market gets it wrong all the time. What happens, how those two are brought into line, is over time, the market absorbs millions of points of

light and fundamentals always rear their ugly head. Eventually, eventually, over the medium and the long term, valuation will rule the day. At least that's what I found. The problem is it's hard to stay liquid. There's that saying that the markets can stay irrational for longer than you can stay liquid. But over the long term,

valuation traditionally trumps price. Okay, thanks, Scott. Now, before we close, I love the ending to the story of you and Cy, the stockbroker. Could you tell us what happened? The fun part of the story is I tell the story in my class and I say I lost touch with Cy Cordner. And a couple of my classmates sent me an email saying we found Cy. And this was about 10 years ago. And he's in his 70s now, maybe even early 80s, living in Sacramento. He gave up being a broker. And he owns a series of stores that sell mink coats or fur

coats. And he and I reestablished a relationship and we're back in touch. And it's just a really nice story about a man taking an interest in a boy's life for no real economic reason other than to be a good person. He wasn't trying to pitch my mom on investments or anything like that. And also, it just paid off hugely for me. And it's a lesson to me as a man myself that, you know, as men, I think we have an obligation if we recognize some success to take a certain amount of our own time and take a vested interest in the well-being of a boy or a girl that isn't our own. That's all for this episode. Our producers are Claire Miller and Jason Staver. Special thanks to Catherine Dillon, Ed Elson,

Mia Silverio, and the PropG Media team. If you like what you heard, please follow, download, and subscribe. Thank you for listening to PropG Markets from the Vox Media Podcast Network. We will catch you next week. Hey, it's Scott Galloway. Thank you. and the senior AI reporter for The Verge to give you a primer on how to integrate AI into your life. So, tune into AI Basics, How and When to Use AI, a special series from Pivot sponsored by AWS, wherever you get your podcasts. What software do you use at work?

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