When you begin investing in stocks, it's important to understand how you might actually be able to make money from owning them. Though it seems complicated, at its core, it's quite simple.
- By investing in stocks, you can collect cash dividends or share in the proportional growth of the earnings per share.
- You can also receive earnings for every $1 in profit that a company generates based upon the level of panic or optimism in the economy, which in turn drives the valuation multiple.
- Whenever you are considering buying stock in a company, write down all three components along with your projections for them.
How You Make Money by Investing in Stock
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 over 25 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 billions of dollars in net income per annum.
At all times, the third component, the valuation multiple, is fluctuating. However, it has averaged 15 times earnings historically in the United States. That is, the market has historically been willing to pay $15 for every $1.00 in net profit a firm generates.
Projecting Future Returns from 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 15. Suppose the S&P 500 were valued slightly lower at a p/e ratio of 14.07.
At those prices, there's considerable evidence that an investor who is 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.
Over the next 50 years, the same $10,000 investment could grow into $294,570 in real, inflation-adjusted terms. That is a 30-year-old person parking money until they're almost Warren Buffett's age.
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 chance 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 or 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.