If you’ve spent a lot of time on the site, you see that we
provide resources on some pretty advanced topics – financial statement
analysis, financial ratios, capital gains tax strategies, and more. Our focus,
however, is on the new investor. I receive emails from readers that ask some
pretty basic and straightforward questions. One of the perennial favorites is,
“How do I actually make money from a stock?” If you’ve ever wondered how the
mechanics actually work, grab a hot cup of coffee, get comfortable in your
favorite reading chair, and prepare to learn the basics of common stock.
When you buy a share of stock , you are buying a piece of a
company. Imagine that Harrison Fudge Company, a fictional business, has sales
of $10,000,000 and net income of $1,000,000. To raise money for expansion, the
company’s founders approached a Wall Street underwriting firm (an investment
banker) and had them sell stock to the public. They might have said, “Okay, we
don’t think your growth rate is great so we are going to price this so that
future investors will earn 9% on their investment plus whatever growth you
generate … that works out to around $11,000,000+ value for the whole company
($11 million divided by $1 million net income = 9% return on initial
investment.)” Now, we’re going to assume that the founders sold out completely
instead of issuing stock to the public (for an explanation of the difference,
see Investing Lesson 1: Introduction to Wall Street .)
The underwriters may say, “You know, we want the stock to
sell for $25 per share because that seems affordable so we are going to cut the
company into 440,000 pieces, or shares of stock (440,000 shares x $25 =
$11,000,000.) That means that each “piece” or share of stock is entitled to
$2.72 of the profit ($1,000,000 profit ÷ 440,000 shares outstanding = $2.72 per
share.) This figure is known as Basic EPS (short for earnings per share.) In
other words, when you buy a share of Harrison Fudge Company, you are buying the
right to your pro-rata profits. Were you to acquire 100 shares for $2,500, you
would be buying $272 in annual profit plus whatever future growth (or losses)
the company generated. If you thought that a new management could cause fudge
sales to explode so that your pro-rata profits would be 5x higher in a few
years, then this would be an extremely attractive investment.
What muddies up the situation is that you don’t actually see
that $2.72 in profit that belongs to you. Instead, management and the Board of
Directors have a few options available to them, which will to a large degree
determine the success of your holdings:
It can send you a cash dividend for some portion or the
entirety of your profit. This is one way to “return capital to shareholders.”
You could either use this cash to buy more shares or go spend it any way you
see fit.
It can repurchase shares on the open market and destroy
them. For a great explanation of how this can make you very, very rich in the
long-run, read Stock Buy Backs: The Golden Egg of Shareholder Value.
It can reinvest the funds into future growth by building
more factories, stores, hiring more employees, increasing advertising, or any
number of additional capital expenditures that are expected to increase
profits. Sometimes, this may include seeking out acquisitions and mergers.
It can strengthen the balance sheet by reducing debt or
building up liquid assets.
Which way is best for you? That depends entirely upon the
rate of return management can earn by reinvesting your money. If you have a
phenomenal business – think Microsoft or Wal-Mart in the early days when they
were both a tiny fraction of their current size, paying out any cash dividend
is likely to be a mistake because those funds could be reinvested at a high
rate. There were actually times during the first decade after Wal-Mart went
public that it earned more than 60% on shareholder equity. That’s unbelievable.
(Check out the DuPont desegregation of ROE for a simple way to understand what
this means.) Those kinds of returns typically only exist in fairy tales yet,
under the direction of Sam Walton, the Bentonville-based retailer was able to
pull it off and make a lot of associates and stockholders rich in the process.
Berkshire Hathaway pays out no cash dividends while U.S.
Bancorp has resolved to return more 80% of capital to shareholders in the form
of dividends and stock buy backs each year. Despite these differences, they
both have the potential to be very attractive holdings at the right price (and
particularly if you pay attention to asset placement) provided they trade at
the right price. Personally, I own both of these companies as of the time this
article was published and I’d be upset if USB started following the same
capital allocation practices as Berkshire because it doesn’t have the same
opportunities available to it as a result of the prohibition in place for bank
holding companies.
The Two Ways You Make Money
Now that you see this, it’s easy to understand that your
wealth is built in two distinct ways:
An increase in share price. Over the long-term, this is the
result of the market valuing the increased profits as a result of expansion in
the business or share repurchases, which make each share represent greater
ownership in the business as a percentage of total equity. In other words, if a
business with a $10 stock price grew 20% for 10 years through a combination of expansion
and share repurchases, it should be nearly $620 per share within a decade as a
result of these forces assuming Wall Street maintains the same
price-to-earnings ratio.
Dividends. When earnings are paid out to you, these funds
are now your property in that you can either use them to buy more stock or go
to Vegas and blow it all at the craps table.
Occasionally, during market bubbles, you may have the
opportunity to make a profit by selling to someone for more than the company is
worth. In the long-run, however, the investor’s returns are inextricably bound
to the underlying profits generated by the operations of the businesses which
he or she owns.
For more information, read our Investing in Stocks guide.
No comments:
Post a Comment
Leave your thoughts here.