SHARE VALUATIONS—HOW STOCK PRICES WORK

As an investor, it’s important to understand what exactly a share is, and what you are paying for as an investor. If you follow the media, you may assume that good news means stock prices go up and bad news means stock prices go down. That may often be true in the short term, but there’s a bit more to it in the long term.

Over the long term, earnings drive stock prices. But how exactly do earnings determine stock prices? In this article, we discuss what exactly a share is and what the stock price represents. If you understand a few fundamentals, then concepts like PE (price-earnings ratio) and price-to-book ratios will make a lot more sense to you.

What are shareholder rights?

A common share is—as the name implies—a share in the ownership of a company. Each share has an equal stake in the company.

Common shares come to the following rights:

  • An equal share of any dividends that are paid.
  • The right to proceeds of liquidation after creditors have been paid.
  • Ownership of an equal portion of the company.
  • The right to transfer ownership to someone else.
  • Voting power on major issues.
  • The right to access information about the company.
  • The right to sue the company for wrongful acts.

The first two rights are the basis for the value of a company. Shares can be valued based on expected future cashflows OR on the basis of the assets the company owns.

Buying cashflows—dividends

There are two ways to consider cashflows—dividends per share and earnings per share. First, let’s consider dividends with an example. 

(This is an oversimplified example. In the real-world dividend payments are not this stable, and neither is interest rates. Shares are also riskier than bank accounts, so shares always must yield significantly more than a bank account. Furthermore, dividends are compared to bonds rather than bank accounts. However, these examples should illustrate the principle of using cash flows to value a share.)

Imagine you have $100 and you know for certain that you can earn 3% interest in a bank account and that the interest rate won’t change. So, you can put the money in a bank account and receive $3 every year until you withdraw your $100.

Now imagine a company’s shares are trading at $100 and you know for certain the company will pay a $3 dividend each year. In this case, owning one share would be exactly the same as depositing the money in a bank account. You would receive $3 every year and at any stage, you could sell the share for $100. It would continue to trade at $100 because it would always be equivalent to depositing money in the bank.

Now, let’s consider a company paying a dividend of $2.50. If the share price was $100 this would be a lower return than the bank account. But what if the share price was $80? The return would then be 2.5/75, or 3.33%. The share would then be more attractive than the bank account because it would yield more.

If the dividend was $6, then any share price up to $200 would give you a better return than the bank. If you could buy the share for $150 (assuming you have more than the original $100) you would be earning 6/150, or 4%.

This is how dividends can be used to determine a share price that yields a better return than a bank account. But in the real world, if a company can grow its profits, it can grow its dividend payout too.

Let’s imagine a company is going to pay a $1 dividend this year and after that, the dividend will increase by 25% each year. That means that by year 10, the dividend will be $7.45. In total, the company will pay out $33 in dividends over ten years, with an average yield of 3.33%. So, although the current dividend is just $1 compared to $3 from the bank, over ten years the share will yield more than the bank account. In addition, the share will be worth a lot more after ten years because it will be yielding $7.45. This is how equity investors earn increasing dividends while the share price also increases.

What about earnings?

Back in the real world, investors are usually more concerned with earnings than with dividends, and this can cause some confusion. Only dividends, not earnings are paid to shareholders. So, if earnings don’t go to shareholders, why would an investor pay for future earnings?

Earnings per share are the company’s profits divided by the number of shares. A portion of the earnings is paid as a dividend, while the remainder is reinvested. This portion is known as retained earnings. Most mature companies pay around 30% of their profits out as a dividend and reinvest the rest. But some companies pay no dividend and reinvest all the profits in the business. So why are investors prepared to pay for shares that pay no dividends?

The reason is as follows. The more a company reinvests, the faster it can grow. And faster growth means higher profits. If a company pays out more of its profits as a dividend, the current yield will be higher. But, if it retains more of those profits, the potential yield in the future will be higher.

If the company can generate a higher return on the capital it reinvests than you can on the cash you receive as a dividend, then it is in your interest for the company to retain those earnings.

This is why expected future earnings are the most important metric for valuing a company. When you use earnings to value a company, you are considering the dividend it would be able to pay out in the future, and what that dividend would make the company worth at that point.

Buying assets

There is another very different way to value a company. If the company owns assets worth $1 million but you can buy the entire company for $750,000, you can obviously make a $250,000 profit by buying the company and selling its assets.

Value investors look for situations where the market is valuing the company below its NAV (net asset value) because they think earnings will be worth very little. If you can buy a stock for less than the NAV per share, you know the worst-case scenario is that the company is liquidated, and the value of the assets is distributed to shareholders. The best-case scenario is that earnings recover, and the company’s value based on expected future earnings rises above the NAV again.

 

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