Introduction
“In the short run, a market is a voting machine, but in the long run, it is a weighing machine.”
-Benjamin Graham.
What did the father of value investing, Benjamin Graham, actually mean when he made up this quote?
He explained this concept by saying that in the short run, the market is like a voting machine – sizing firms based on fickle popularity. However in the long run, the market is like a weighing machine by assessing the substance of a company. The message is clear, what matters in the long run is a company’s actual underlying business performance (earnings) and not the investing public’s fickle opinion about its prospects in the short run.
Over the long term, when companies perform well, their shares will do so, too. And when a company’s business suffers, the stock will also suffer.
The next important question is – what does the weighing machine weigh?
The answer is EARNINGS. Interested to learn more about how earnings drive long term compounding of share prices?
Read on!
The Power of Retained Earnings
The historically great investment gurus like Warren Buffet, Edgar Smith, and John Keynes have all commonly stated that the magic of retained earnings is fundamental to why stocks grow exponentially over long periods of time.
To be a credible long term investor, it is a must to understand this logic, and what assumptions go into determining stock prices based on retained earnings.
What did Buffet say about Retained Earnings
Not very long ago in 2019, Buffet wrote a letter to Berkshire shareholders, with a section titled “The Power of Retained Earnings”.
In that letter Berkshire confirms his predecessors’ (Smith, and Keynes) belief that businesses that continually re-invest retained earnings into the businesses can deliver significant benefits to shareholders by compounding the portion of earnings that are reinvested into the company.
Stagnant Earnings, Stagnant Stock Prices
Do you know that if a company continues to earn the same earnings year in year out, in theory the stock price goes nowhere?
Let’s explain this using numbers.
Assume a stock has 1M outstanding shares, and earns $10M worth of retained earnings each year. Let’s also assume this $10M earnings remains constant over time.
Effectively, the Earnings per Share (EPS) works out to be $10 per share ($10M/1M Shares).
Let’s further assume shareholders are distributed the full amount of the $10M earnings via a $10 per share dividend.
Now let’s take this further by assuming a shareholder expects a 12% return per year from owning this business.
Therefore how much should this shareholder pay?
The maths is simple, since each share provides a $10 dividend per year, to achieve a yearly 12% return we should pay $100 per share, since 12% of $83.33 = $10 to get the required 12% return.
Now let’s fast forward 5 years from now.
Let’s say another person wishes to buy shares and similarly expects 12% return. How much should he pay per share?
The answer is that since the dividend payment per year is the same $10 per share, to get a 12% return the share price needs to be $83.33.
Note there is no difference in share price year 1 and 10 years ago – why? Because there is no change in dividend amount.
When retained earnings do not grow, neither will the stock price, all things being equal. |
Growing Earnings, Compounding Stock Prices
Hence, in the long run, only businesses that can compound their intrinsic value exponentially can also see exponential growth in their share prices.
By intrinsic value we mean fundamentals like earnings, cash flows, and dividends MUST grow exponentially over time.
Let’s perform a simple illustration here by changing assumptions to see what happens to share prices when intrinsic value increases.
Let’s assume the dividends grow 10% per year. Do you know that (the maths is complicated) just because there is dividend growth, the stock intrinsic value becomes $500/share?
In 5 years time, it will grow to $805.25/share.
A business that delivers exponentially growing per share dividends over time, the stock price to ALSO be expected to grow exponentially at the *same* rate. As time passes, businesses that return MORE cash to shareholders become MORE valuable. |
The real world is more complicated
The problem with reality is that businesses that make profits (have retained earnings) do not usually pay all of them out to shareholders via dividends.
The reason is very simple. To continue to increase profitability, businesses need capital to fund new growth. Short of issuing debt, one other way is to reinvest the earnings into the businesses to fund growth.
That means only a part of earnings are issued to shareholders.
This is where things get complicated – how do shareholders determine whether these earnings reinvestment will drive intrinsic value increase?
The general rule of thumb is that businesses that are able to successfully execute this loop year after year by earning good returns on both “legacy” capital and “new” capital added via retained earnings each year — tend to deliver exponentially growing stock prices over the long run. |
FINAL WORDS
- When retained earnings do not grow, neither will the stock price, all things being equal.
- A business that delivers exponentially growing per share dividends over time, the stock price to ALSO be expected to grow exponentially at the *same* rate.
In reality businesses do not give out all profits as dividends, and tend to reinvest them into the business to continue to grow. This is where it becomes difficult for normal shareholders to determine whether ‘intrinsic value’ has been eroded over time.
Please note that all the information contained in this newsletter is intended for illustration and educational purposes only. It does not constitute any financial advice/recommendation to buy/sell any investment products or services.
