Profit is a Necessary Condition for a Long-Term Winner in the Stock Market

In the short term gains on a stock may seem unrelated to the underlying profits (earnings) of the company. After all, companies only report earnings four times per year and yet stock prices gyrate up and down by the hour and sometimes change by a large percentage without any earnings or any other news from the company.

One of our articles explains in detail that all gains in the stock market can be divided into two sources: 1. gains made at the expense of other stock market investors and 2. gains made from the underlying company selling goods and services to customers at a profit.

Over the entire life of a company, 100% of the aggregate returns (or losses) to the entire aggregate population of investors must come from the profits or losses of the company itself. Gains and losses made by investors trading shares amongst themselves must cancel out to zero.

• In the short term there can be big gains made by trading astutely.

• In the long-run stock returns are driven by the earnings of the underlying company.

• Imagine a stock that has returned a compounded average of 10% per year for ten years years.

Here are some ways that this could happen.

1. The stock paid no dividend and the P/E ratio has remained constant. In this case the entire return has come from an increase in the stock price. The stock price must have risen 159% over the ten years, for example from $10 to $25.90 ($10 times 1.10 to the tenth power is $25.90). 

With no dividend and with no change in the P/E ratio, the annual return on the stock is precisely equal to the growth in the earnings each year. All of the return is clearly provided by earnings which come from selling products and services to customers.

2. The stock paid no dividend but the P/E ratio rose by 25% (say from 10 to 12.5). If the P/E ratio rises 25% then that is of course a gain or return of 25%. If this occurs over ten years then this is 2.2565% per year (1.022565 to the tenth power is 1.25). 

In this case the return due to earnings gain must be 2.59/1.25 equals 2.072 times or 107% or 7.557% per year. Starting with a $10.00 stock earning $1.00, the earnings would rise to $2.072 per year which at the 25% higher P/E of 12.5 results in a stock price of $25.90.

3. The stock paid out a 5% dividend yield and the P/E remained constant. In this case 5% of the return would come from the dividend and the earning would need to grow at 5%. The $1.00 earnings would grow to $1.63. The remaining return would come from the dividend to total 10% per year.

4. The stock paid out all of its earnings as a dividend and the P/E remained constant. In this case the stock price may have remained constant and therefore the earnings may have remained constant and all of the 10% return would have come from a constant 10% dividend yield.

5. The stock paid no dividend and the earnings remained constant. In this case the P/E must have risen 159%, or an average of 10% per year. That seems an unlikely scenario. A P/E ratio would rarely rise much with flat earnings and no dividend. It could happen though if there was reason to expect large profits in the future.

In order for any company to provide a very attractive long-term return such as 10% per year for 10 years, it is almost imperative that the company have earnings (rare exceptions exist where the big profits are expected to come in the future but have not yet materialized). 

In addition, in most cases the earnings must grow at a strong rate for this to happen. In lieu of earnings growth, a very high dividend coupled with relatively flat earnings could achieve the 10% per year return. 

Generally one could say that a company that is to provide strong returns in the long term must deliver growth or dividends or some acceptable combination of both. In order to achieve a 10% long-term return at a constant P/E level the dividend yield plus the growth in earnings per share must total to approximately 10%.

Source Shawn C. Allen, CFA, CMA, MBA,P. Eng. - InvestorsFriend Inc.