This short essay will answer the following questions: 1) What gives an asset investment value? 2) Why do individual company stock prices rise over time? 3) Why does the general stock market rise over the long-term?
What gives an asset investment value?
Investment value is simply cash that can be taken out of an asset and put in your pocket. If we understand how much cash an asset will produce and when it will produce it, there’s a simple formula for figuring how much investment value it has.
Imagine a box that contains $10 cash. This box is available for purchase today but has a special time-lock that only allows it to be opened in one year. What is this box worth to you in today’s dollars? Or as Aesop might put it, how many birds in the hand are worth the 10 in the bush?
Intrinsic value = Cash Flow / (1 + Required Return rate)
($10 / 1 + 10% return) or ($100 / 1.1). The answer is $9.09. That’s the dollar amount you can logically pay today in order to generate a 10% return when you receive the $10 cash in a year. This $9.09 figure represents the box’s intrinsic value. It’s the value of the box regardless of what’s happening in China or what the Federal Reserve is doing.
Finally, imagine that after the $10 is pulled out of the box, it gets replenished with 10% more cash, or $11. If we perform the same calculation, the intrinsic value figure will also rise by 10%. This effect has important implications for shareholder returns when corporate profits are being reinvested.
Why does the stock price of an individual company rise over time?
Stock prices move around for all kinds of reasons in the short term. In the long term, prices reflect intrinsic business value. Ben Graham summed up this idea when he said, “In the short term the market is a voting machine, and in the long term it’s a weighing machine.”
Imagine a farm that starts with $100 in equity (net assets). It sells wheat for a year and earns $10 on that investment, or a 10% return on equity. The company may use the $10 to a) pay dividends b) repurchase shares c) reinvest earnings.
Say the company chooses to reinvest all earnings. The company’s net assets are now $110 ($100 + $10). Because of the increased investment in land and tractors it sells more wheat and earns $11 in Year 2, again a 10% return on its shareholder equity ($11 / $110). If it keeps repeating this process year after year and maintains the same return on equity, the profits will grow at 10% compounded annually.
An asset that produces 10% more profit year after year is building intrinsic business value at that very same rate. If you own publicly traded shares you’re going to see annual price appreciation at same rate as well, albeit it in irregular fashion.
To best illustrate the effect of compounding retained earnings, let’s look at Berkshire Hathaway: Over the last 50 years the company has paid $0 dividends, and spent almost nothing on stock repurchases. Basically every dollar has gone towards reinvestment. The company’s rate of return on reinvested earnings has averaged roughly 20%. Let’s look at what this has done for shareholder returns:
See 2014 Annual Report Berkshire Performance vs. the S&P 500 page.
“Since 1970, our per-share investments have increased at a rate of 19% compounded annually, and our earnings figure has grown at a 20.6% clip. It is no coincidence that the price of Berkshire stock over the ensuing 44 years has increased at a rate very similar to that of our two measures of value.” – Berkshire Annual Report 2014
Why does the general stock market rise over the long-term?
The same investment math that governs the outcomes of individual companies applies to the valuations of the general stock market. The indexes rise because the aggregate earnings of the underlying companies increases year after year. The capital investment required to produce these increases has been funded through trillions of dollars in retained earnings.
And look how it’s grown: In January of 1965, the S&P 500 had earnings per share of 35.67 and traded at a valuation of 667. Over the following 50 years to January of 2015 those earnings per share grew to 103.*
If earnings per share grew by a factor of 2.89, and earnings determine business values, how much higher would you expect the S&P 500 to be valued at now compared to 1965? Without surprise, in January of 2015 the S&P 500 was valued 2.99 times higher, when it traded at 1,993.
Over this time period there have been wars, recessions, and countless boneheads elected to run our national government. You can’t begin to count all the reasons for market prices to drop. Yet American business prospers, profits grow, and valuations follow.
*Source: Macrotrends.net
