Why Invest in the Stock Market

In this month’s wealth pipeline we endeavour to explain the potential attractiveness of investing in the stock market.  We do this by going back to basics.

Why Invest in the Stock Market 

When we invest in a company listed in the stock market an investor is actually purchasing a ‘share’ of the underlying profits of a company.

Let us look at a simple example.  A company invested $50 million in various assets (inventory, plant etc) and in the current year will earn profits of $10m.  The business is growing at 10% p.a. so the company needs to invest an additional $5m (i.e. 10% of the $50m in assets) to support this growth.   It can distribute the remaining $5m of the profits as dividends.  There are 100 million shares on issue which are listed on the stock market and are currently trading at $1.20 giving the company a market capitalisation (value) of $120m.

The expected return from investing in this company can be looked at in the following way:

Earnings Yield = profits/market value = $10m/$120m = 8.3%.

I.e. our $1 invested in this company at the current share price is returning 8.3% in the form of our share of the underlying profits.

Usually this concept is expressed by stock market participants as the inverse i.e. the market value (or price) divided by the profits (or earnings) equals the price earnings multiple (P/E).  In this case the expected P/E of the company is:

P/E = market value/profits = $120m/$10m = 12.

We expect part of these earnings to be paid out as a divided:

Dividend Yield = dividend/market value = $5m/$120m = 4.2%.

In this example, the investor is expecting to receive an initial earnings yield of 8.3%, of which 4.3% is received as a dividend.

However as the business is growing, the earnings yield and the dividend can improve each year. Suppose the business continues to grow at a steady 10% p.a., five years down the track profits will be $16.1m and the dividends $8.1m.  Based on the initial purchase price today, the earnings yield and dividend yield will be 13.4% and 6.8% respectively.

Stock prices will of course move with the company’s fortunes, so let’s say that new investors in the shares are still satisfied by an initial earnings yield of 8.3%, the market value will now be 12 times earnings of $16.1m ($193m) or $1.93 for each share.  So the investor will now have made a capital gain of approximately 61% cumulatively over five years as well as receiving a healthy dividend each year.

In this simple example, the return to the investor is determined by the:

1. Initial valuation,
2. Subsequent performance of the business, and
3. The valuation of the company at the end of the period.