“The stock market is nothing more than a ponzi scheme”
“It’s all just fake money”
“Stocks prices are completely arbitrary. It can rise or crash any day”
Chances are, you’ve heard some variation of the above, many times in your life. It’s hardly surprising – stocks play a crucial role in our economy and personal savings. And yet, most people have no idea what causes stock prices to go up or down. Hence the conclusion that stock valuation is completely and utterly arbitrary, with little room for rational analysis.
The truth however, is the opposite. Anyone who has spent some time studying the fundamentals of finance, can tell you why stocks are valued the way they are, and what it portends for the long-term future.
The weather makes for a remarkably good analogy – it’s incredibly hard to predict the weather over the next week. But with even an elementary understanding of seasons, it’s easy to understand temperature fluctuations over the longer term. The same is true of stocks, and in this post, we shall explore how stocks generate long-term returns. We shall also use this knowledge to estimate the long-term returns we can expect from stocks, given today’s circumstances.
The key to understanding stocks, is that almost all valuations and returns are driven by corporate earnings. Ie, profits. There are numerous variations of this – short-term vs long-term profits, realized vs projected profits, volatile vs steady profits, etc etc. There are many other second-order factors as well, such as human psychology. But these are also predicated on the foundation that underpins stock valuations: how much profits the company will be making.
To give a simple example, suppose company XYZ has 1 million outstanding shares, valued at $1000 each, giving it a total valuation of $1B. Suppose also that this company has yearly profits of $50M. The earnings-per-share for XYZ is then $50M/1M = $50. Suppose you now purchase one share of XYZ. You have paid $1000, and in return, your slice of the yearly profits are $50.
Suppose XYZ’s business is perfectly stable, and that the CEO decides to give you your entire slice of the profits (ie, dividends), every year in perpetuity. In such a scenario, your investment is identical to putting $1000 into a bank which pays out $50 in interest annually. The interest rate you’re getting in such a scenario, is simply the earnings-per-share, divided by the share-price. Ie, 50/1000 = 0.05 => 5%. In the world of finance, this term is referred to as the Earnings Yield. Perhaps better known by its cousin: PE Ratio, which is simply the inverse of the Earnings Yield.
Of course, if things were really that simple, we wouldn’t need banks at all. For one thing, companies usually don’t return all of their earnings to their investors, ever year. Often times, the board would decide that it is in their investors’ best interests to reinvest the earnings or to buyback outstanding shares using that money instead. In both cases though, this is only done in the shareholders best interests. So even if you aren’t getting the money immediately, it should (in theory) leave you even richer in future.
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