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When you begin investing in stock, it's important to understand how you might actually be able to make money from owning the stock; to intimately have a grasp on how the increase in wealth is generated for you assuming you've selected your position wisely. Though it seems complicated, at its core, it's quite simple.
Let's take a moment to look at investing in stocks to illustrate how simple the process is.
The future value of stock must equal the sum of three components:
That is it. Those are the only three ways that someone who invests in stock can benefit economically. He can collect cash dividends, he can share in the proportional growth of the underlying earnings per share, and he can receive more or less for every $1.00 in profit a company generates based upon the overall level of panic (fear) or optimism (greed) in economy, which in turn drives the valuation multiple, also known as the price-to-earnings ratio.
For some companies, such as AT&T, the first component (dividend yield) is substantial. For others, such as Microsoft for the first 20 years, it isn't because all of the return comes from the second component (growth in intrinsic value per fully diluted share) as the software giant grew to tens of billions of dollars in net income per annum.
At all times, the third component, the valuation multiple, is fluctuating but has averaged at 14.5x earnings for the past 200 or so years in the United States. That is, the market has historically been willing to pay $14.50 for every $1.00 in net profit a firm generates.
Imagine you want to invest in a lemonade stand that has only one (1) share of stock outstanding.
The lemonade stand owner offers to sell you this share of stock. Your initial dividend is 4%. The business grows at 10% annually. You hold the share for 25 years and expand the company before selling it.
The historical price to earnings ratio for the stock market is 14.10. When I originally penned this article, the S&P 500 was valued at a p/e of 14.07.
At those prices, I think there was considerable evidence that an investor buying and holding a low-cost index fund such as the S&P 500 for the next 25+ years and reinvesting all dividends have a good probability of earning the historical real (inflation-adjusted) rate of return on capital of 7% compounded annually. In terms of purchasing power, that would turn every $10,000 invested into $54,274 before taxes, which might not be owed if you held your securities through a tax-advantaged account such as a Roth 401(k) or Roth IRA.
Over the next 50 years, the same $10,000 investment could grow into $294,570 in real, inflation-adjusted terms. That is a 30-year-old man or woman parking money until he or she is Warren Buffett's age.
Stated another way, if you are a 30-year-old investor and you put $100,000 in an S&P 500 index fund through a tax-advantaged account, you have a very good shot at having purchasing power equal to $3,000,000 by the time you are Warren Buffett's age without ever saving another penny.
Looking at your stock investments rationally is the only intelligent way to manage your wealth. Whenever you are considering acquiring ownership in a business - which is what you are doing when you buy a share of stock in a company - you should take out a piece of paper or index card and write down all three components, along with your projections for them.
For example, if you are thinking about buying shares of stock in Company ABC, you should say something along the lines of, "My initial dividend yield on cost is 3.5%, I project future growth in earnings per share of 7% per annum, and I think the valuation multiple of 25x earnings that the stock currently enjoys will remain in place."
Seeing it on paper, if you were experienced, you'd realize that there is a flaw.
A 25x multiple for a stock growing at 7% per annum in today's world is too rich*. The stock is overvalued, even on a simple dividend-adjusted PEG ratio basis. Either the growth rate needs to be higher, or the valuation multiple needs to contract. By facing your assumptions head-on, and justifying them at the outset, you can better guard against unwarranted optimism that so often results in stock market losses for the new investor.
*Valuation multiples, or the inverse earnings yields, are always compared to the so-called "risk-free" rate, which has long been considered the United States Treasury bond yield.
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