The 3 Ways You Can Make Money Investing in a Stock
There Are Only Three Possibile Sources of Profit for You as an Outside Investor
There are only three ways that someone who invests in stock can benefit economically.
- They can collect cash dividends.
- They can share in the proportional growth of the underlying earnings per share.
- They can receive more or less for every $1.00 in profit a company generates based upon the overall level of panic (fear) or optimism (greed) in the economy, which in turn drives the valuation multiple, also known as the price-to-earnings ratio.
For some companies, the first component (dividend yield) is substantial. For others, such as Microsoft for the first 20 years, it isn't, as all of the return comes from the second component (growth in intrinsic value per fully diluted share) as the software giant grew to tens of billions of dollars in net income per annum.
At all times, the third component, the valuation multiple, is fluctuating. However, it has averaged 14.5 times earnings for the past 200 or so years in the United States. That is, the market has historically been willing to pay $14.50 for every $1.00 in net profit a firm generates.
Projecting Future Returns Stock Market Investments
The future value of stock must equal the sum of three components: The initial dividend yield on cost; the growth in intrinsic value per share (for most firms, this amounts to the growth in earnings per share on a fully diluted basis); and the change in the valuation applied to the firm's earnings or other assets, often measured by the price-to-earnings ratio.
The historical price-to-earnings ratio for the stock market is 14.10. And let's say the S&P 500 is valued at a p/e of 14.07.
At those prices, there's considerable evidence that an investor buying and holding a low-cost index fund such as the S&P 500 for the next 25-plus years and reinvesting all dividends has a good probability of earning the historical real (inflation-adjusted) rate of return on capital of 7% compounded annually. In terms of purchasing power, that would turn every $10,000 invested into $54,274 before taxes, which might not be owed if you held your securities through a tax-advantaged account such as a Roth 401(k) or Roth IRA.
Stated another way, if you are a 30-year-old investor and you put $100,000 in an S&P 500 index fund through a tax-advantaged account, you have a very good shot at having purchasing power equal to $3,000,000 by the time you're well over retirement age without ever saving another penny.
One Approach to Investing Your Money
Whenever you are considering acquiring ownership in a business—which is what you are doing when you buy a share of stock in a company—you should write down all three components, along with your projections for them.
For example, if you're thinking about buying shares of stock in Company ABC, you should say something along the lines of, "My initial dividend yield on cost is 3.5%, I project future growth in earnings per share of 7% per annum, and I think the valuation multiple of 25x earnings that the stock currently enjoys will remain in place."
Seeing it on paper, if you were experienced, you'd realize that there is a flaw. A 25x multiple for a stock growing at 7% per annum in today's world is too rich. (Valuation multiples, or the inverse earnings yields, are always compared to the so-called "risk-free" rate, which has long been considered the United States Treasury bond yield.)
The stock is overvalued, even on a simple dividend-adjusted PEG ratio basis. Either the growth rate needs to be higher, or the valuation multiple needs to contract. By facing your assumptions head-on and justifying them at the outset, you can better guard against unwarranted optimism that so often results in stock market losses for the new investor.
The Balance does not provide tax, investment, or financial services and advice. The information is being presented without consideration of the investment objectives, risk tolerance, or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk including the possible loss of principal.