Essential Basic Math for Investors
The fundamental essence of investing in stocks is to buy a share in a company
and make an acceptable return over a holding period through a combination of
dividends and capital gains.
True investing requires a planned holding period of at least one year although
in many cases you may plan to hold the stock indefinitely for
many years.
A planned holding period of less than one year is an operation in pure
speculation or gambling, rather than investing.
An acceptable company for investment should have a high probability of making
a positive return and only a very small probability of incurring a significant loss if held
for several years.
Returns on a stock will come from: 1. Dividends collected over the holding period
and 2. The (hoped for) capital gain on ultimate sale of the stock.
The capital gain is fueled by two things, first the growth in earnings. For
example, if a
stock is bought at a P/E of 12 and its earnings double over a five year period,
then the stock will yield a capital gain of 100% if the P/E remains at 12.
The second driver of the capital gain or loss is the change in the P/E ratio.
If you buy a stock with a P/E of 12 and the P/E changes by 50% to 18, over any
period of time then this yields a 50% capital gain, assuming earnings are
unchanged.
The P/E is fueled by investor outlook for earnings growth and the general
market sentiment. Changes in the P/E account for most day to day stock
volatility.
But, ultimately over longer periods of time earnings growth will determine the
capital gain since earnings growth produces capital gains at a constant P/E and
is also the main driver of changes in the P/E.
Therefore, investors should be very concerned about the expected growth in
earnings per share ("EPS").
Growth in EPS is the buoyancy force that drives up the value of a stock. Your goal
should be to buy companies with strong EPS growth potential AND IMPORTANTLY to
buy them at prices that reflect a lower EPS growth. For example, if a stock
price is implicitly pricing in 20% EPS growth, then you can expect to lose money
if the EPS ultimate grows at "only" 15%. You must seek to buy stocks
that will grow EPS at a higher rate than the growth that you are implicitly
paying for when you buy the stock. This is a fundamental concept that most
investors (and even most advisors) simply do not understand. You are ahead of
the game if you understand this.
Any dividends and growth in dividends are also buoyancy forces that drive stock
values up.
The required rate of return on investment is a gravitational force that
pulls stock
values down.
Investors require a return on investment. If you require a 5% return on your
investment then you should be willing to pay up to $7.84 today for a guaranteed
payment of $10.00 five years from now. However, if you require a 10% return
(perhaps because you have alternative uses for the money that will return 10%)
then you would now be willing to pay no more than $6.21 today for that same
guaranteed $10.00 payment in five years. Your higher required return has acted
as a gravitational force pulling down the value of the investment. The impact of a higher
required return becomes very dramatic over longer periods of time.
The result is some interesting and surprising results.
A stock that pays no dividends MUST grow its earnings at at least the same
rate as your required return. (Assumes no change in the P/E).
If you want to make a 9% return on a non-dividend paying stock, then that
company MUST grow EPS at at least 9%. Often such a company would brag if
earnings grew at 8%, but the fact is that this is a losing investment for you.
Surprisingly, if you must make 9% on your money and the non-dividend paying
company can only grow earnings at 8%, then the stock is ultimately worthless to
you!
Consider a non-dividend paying company that is selling at $12.00 and earning
$1.00 per share and therefore selling at a P/E of 12. Now imagine that the
earnings will remain at $1.00 per share for ten years (because management keeps
investing the earnings in bad projects). If the P/E stays at 12 then this
company will still be selling for $12.00 per share in ten years. If you could
forecast all of this and your required rate of return was 9%, what is the value
of that share to you today? The surprising answer is that it is worth $5.07
today. That means this stock with zero growth and zero dividend should only be
selling at a P/E of 5! And if it is assumed to keep on making a $1.00 per share
forever but with no growth and no dividend then in the very long term, it is
actually exactly worthless!
Investors should be aware of the concepts of growth as buoyancy force and
required return as a gravitational force or at least find an advisor who understands this.
Shawn Allen, CFA, CMA, MBA, P.Eng.
March 7, 2003 (last revised March 15, 2003)
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