Part 7: The value of the expected return

What is the value of a share? The stock price can vary one day to another, purely because investors measure the value of the company differently. Company profit is important but so is the interest.

What is the reason people have more interest in stocks in the last few years? Because the interest is low.



Savings accounts, bonds, property, and stocks thus are diametrically opposed to each other.

You can outweigh the pros and cons of each investment against one another. E.g., standard savings accounts in the US is about 2%, on a US treasury bond, you get about 2-3% and company bonds of a good quality offer may be 3-4%. For each of these the profits are low but so is the risk linked to them.

In a direct comparison (see table below), you can see in one glance how much higher the underlying return of profit return is for stocks.

A dividend is proof of profitability

The stock price alone doesn’t show how attractive an investment opportunity a corporation is.

Historically, stocks returned on average per year about 4.5% more than government bonds. Today this so-called risk premium is about 5%. Purely based on the expected return of 2018, the risk premium can rise to 6.4%, as you can read, a lot more than the average. If the profits reach these forecasted numbers, then this risk premium seems to be a very good deal.

As opposed to the interest, nothing guarantees the return of a stock. This is because, as an investor, we can only count on the underlying company profit.

The most direct and tangible return of stocks is the dividend that many companies pay out yearly. This is on average a lot higher than the return of company bonds. This is exceptional and underlines how low the interest rates really are.

Most of the time, dividends are only part of the total return. With leftover profit, a company can reinvest and grow, with the idea that profit per gross will keep increasing.

In other words, it’s very useful to consider the company profit as the return on investment on your stocks. Like the interest of a bond. In the short-term investors can guide a stock up or down, but in the long run, there is a strong correlation between ROI and the stock price.

A company’s capitalization

This stock price in itself says little to nothing about the value of the company. The price must be multiplied by the total number of available stocks: that is the true value of a listed company. The largest corporations in the world weigh in the billions of dollars. On August 2, 2018, Apple even broke the magical barrier of 1000 billion dollars or one trillion.

The market considers a company with a capitalization of less than 100 million a small cap.

When a company is worth your money

Where the stock price doesn’t say much about the true value of a company, the market capitalization, in turn, doesn’t tell you if it’s a worthy investment.

Crucial is to compare the company profit of a given year with its market cap. An example: company X closed 2016 with a net profit of 324 million dollars. You then have to compare it to the total market cap of about 5.4 billion dollars. In short, investors pay 16.6 times the yearly return for the company X’s stock (324 x 16.6 = 5,400).

In practice, investors calculate the profit per share. For the aforementioned company X, we thus divide the 324 million dollars of profit by the total number of shares (e.g. 200 million). In conclusion, company X makes 1.62 dollars of profit per share. This is called the Price-Earnings ratio. You just divide the share price of X by the profit per share of 1.62 dollars: the reverse of 16.6 gives the earnings yield of 6%.

Shares of companies that can increase profitably or reliably, may have a higher valuation (= higher P/E ratio and lower earnings yield).

Remember

  • Even if the stock markets fall, there are those that climb (and vice versa)
  • Buy one thousand dollars’ worth of shares each quarter. If A shares are listed at 10 euros, you will be able to buy 100 of them. If the share falls to 5 euros, you can buy twice as much

Don’t forget to bring your shades for the next part. You don’t want to get blinded by a company’s daily market price. It doesn’t say a whole lot about the value of a stock after all.