Investing in stocks and shares can seem complicated. And of course investing is never completely simple. But there are ways to help make sense of it all.
One way to make sense of it all is to break down where the investment profits come from. If you can understand this better, then you can start to choose more successful investments. The following may look a little technical at first, but I’ll explain it all piece by piece. Hopefully it will then make sense.
Profits (or losses) from stocks and shares can be broken down into three things:
1. Changes in earnings per share (EPS)
2. Changes in the price-to-earnings ratio (P/E)
3. Dividend income received
Listed companies, that is ones that have shares traded on stock markets, have a fixed number of shares at a moment in time. Each year the companies make a profit after tax – also known as net income or net earnings. This profit is the proceeds that the company owners – the shareholders – have made on their investment in the company. Each share has an equal right to those profits. Put another way, the owner of each share has a right to an equal piece of the profits of the company.
So if a company has 100 shares and profits (earnings) of $1,000 then the “earnings per share or EPS” are $10 ($1,000 divided by 100).
Next the shares have a traded price in the market. Continuing the example, let’s say that the price of each share is $200. The price-to-earnings ratio (P/E) is one standard way of assessing how expensive or cheap a company’s shares are. This can be compared with other similar companies, compared with the same company at times in the past, or compared with an estimate of the true value of the shares.
We can get to the price-to-earnings ratio (P/E) two ways. In this example if the price is $200 and there are 100 shares then the total market value of the company is $20,000 ($200 times 100). This is known as the market capitalisation, which is the price to buy the whole company on the stock market. Divide the market capitalisation by the earnings of $1,000 and we get a figure of 20. This is the P/E.
Price to Earning Ratio = Market Capitalization ÷ Earnings
Alternatively we can calculate P/E at the single share level. We already worked out the EPS as being $10, and the price is $200. So P/E is $200 divided by $10, which is again 20.
Understanding this explains how the first two factors in my list affect the share price. If P/E stays at 20 but EPS increases by 10% to $11 then the share price will increase to $220 (20 times $11). This is an increase of 10%, the same as the EPS increase.
Similarly if the EPS stays the same but P/E increases by 10%, from 20 to 22, then the share price will also increase by 10% to $220 (22 times $10).
So a big part of investing in shares is to choose investments where both the EPS and the P/E are likely to increase. Taken together these drive share price increases, which give us capital gains when investments are eventually sold.
If both go up 10%, so EPS is $11 and P/E is 20, then the price will rise to $242. That is a total gain of 21% ($42 gain divided by $200 starting price).
The final piece of the profit comes from dividends. When a company makes cash profits it can choose to re-invest the cash in the business, either for growth or to replace ageing assets. Or it can pay out the cash to the shareholders. Most companies do a bit of both.
Let’s assume that in our example the company pays out 50% of profits as dividends. This 50% is also known as the payout ratio. In this case that is $500 ($1,000 times 50%). Divided by the 100 shares that means the dividend per share (DPS) is $5. And at the price of $200 it means the dividend yield – or percentage profit from dividends – is 2.5% ($5 dividend by $200 as a percentage).
Put it all together and if the EPS grows 10%, P/E grows 10% – giving us 21% combined return – and the dividend is 2.5% then the total gross profit would be 23.5%. Making the best long term returns is all about choosing a portfolio of shares that will profit from this combination of factors. Some will make more from dividends, some more from EPS and some more from P/E increases. But overall our investments must have good chances of profiting from this combination.
The secret to the most successful stock investing is to be a value investor…
In my example here the P/E starts out quite high. The secret to the most successful stock investing is to be a value investor, and find stocks with a much lower P/E than this that look like they could return to higher multiples. You then hold on to them until that happens. In the meantime, if you have invested wisely, you still make profits from the EPS growth and dividends.
A good rule of thumb is to only invest in stocks with a P/E of less than 10, although that is not always the case. Add in the EPS growth and the dividend income and the returns should be highly attractive over time.
Until next time OfWealthers,