I received an email from one of the reader which I thought it was interesting to share and further ponder around on the topic.
He asked me a very beginner question because he is relatively new to the market.
He asked me whether a share price might stay the same after 10 years even if the company continues making profits in that 10 years.
Logically speaking, if the company continues making profit, the share price should grow in tandem after 10 years, assuming everything else constant. It is almost illogical that the share price continues to be the same after 10 years.
The Efficient Market Hypothesis that we learnt in school taught us that markets are efficient. They reflect all new public information as well as the revised numbers announced after results. This means that if the company continues to make a profit, then the profits would flow back to cash in the assets and retained earnings in the equity and it would strengthen the balance sheet, hence the share price should reflect stronger in that very aspect.
In reality, we know that might not always be the case.
One factor is that sentiments in the market play a big part especially when the blind leads the blind and this demand continues to push the market upwards or downwards in momentum, everything else fundamental constant.
This is called herd investing.
During the cusp of the Great Recession in 1929, Joseph Kennedy reflects a story how he at that time heard tips from everywhere including his very own shoe shine boy. He sold everything he owns that very next day.
Sentiments also drive earnings multiple higher in market during the bull or bear run. For example, during a strong wave of bull run, market might assigned a technology company 50x earnings multiple to that company but only 10x multiple during a bear market.
The second factor why share price might remains the same after 10 years can also be attributed to the way they structured their financial engineering books. Some companies might generate an earnings yield of 10% but distribute dividends that are higher than that for example 11%. In that case, the company would have to either fund it via borrowings or issue an equity at some point as a return of capital. This weaken the balance sheet over time and is an example of a poor management capability.
To make things more complicated, there are many companies which has a dividend policy that are attributed to a certain percentage of their dividend to earnings. For example, Company A might have a policy to distribute out at least 80% of the earnings as dividends.
The problem with this as investors might already know is that earnings might not necessarily equate to cash flow, let alone taking a free cash flow into account.
So going back to the same example if you have a company that has an earnings yield of 10%, but gives a dividend yield of 9%, yet the cashflow yield is only 7% and free cash flow yield of only 6.5%, then sooner or later, the company would be facing similar cashflow issues and runs into debt.
The idea why the EMH hypothesis stays true is because it assumes that companies that make profits would plow back its profits into the balance sheet as cash which it would then use it as an opportunity to further invest into projects with an EPV that are greater than zero. In that hypothesis, it assumes that the markets are efficient, the opportunities are readily available and the sky is blue.
And if the share price remains after 10 years, then perhaps it is a sign that the management has not done a very good job at improving shareholders value which in actual sense the only most sensible thing for them to do to increase shareholders value is to payout 100% of their cashflow earnings.
Easier and happier for both parties.
Thanks for reading.
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Hi B,
If the share price remains the same after 10 year but my dividends received has beat inflation rate, I will be happy. Because it is still a "win" situation for me.
Hi MIM
It’s an interesting point there.
I guess if the expectation of an investor is to get the return in the form of dividends received then i think it might makes sense but I would still be slightly disappointed if they have failed to grow the company in a span of 10 years especially when there are still room for growth.
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Hi B,
Make me thinking of SingTel…
Hi PIF
Singtel strikes as one of those stocks too that I saw them 8 years ago when I started investing in 2011 and they still continue to be at this range today. Makes me wonder if the management is effective enough in growing their business overseas or is today’s valuation really depressed.
If dividend yield is above 5%; share price remains fairly the same over 10 years. There is no emotional roller coastal ride. Most of us hate price volatility to cause us paper losses. 🙂
Hi Uncle CW
Haha sounds to me like a corporate safe bond or ocbc preference shares. We enter at the expectation of constant coupon and wait for maturity period.
If buying and not seeing the price movement ( market close for 10 years ) , then collecting 5% dividend p.a should be fine … but the most difficult part is seeing the price increased so much ( made huge paper profit ) and then seeing the price crash again with all the gain gone… that's the most painful ..
Also , another group will be those buying at high ( $4 ) and even collecting the 5% dividend will not be able to cover and capital lost… of course , just by hindsight..
Cheers !!
Hi STE
Indeed the roller coaster ride is playing a big factor in our decision even on hindsight I wonder how starhub shareholders who bought at 10 years ago at this price would feel today. Of course they have pocketed solid amount of dividends that could be close to $2 (10 years x 20 cents) but still perhaps some discomfort deep in the heart.
Hi
I believe based in your previous post (forgive me if I remember wrong) you mentioned about using ROIC as a metric instead of share price to gauge whether a company is good or not.
Some stalwarts (non growing companies) might pay out most of its earnings as dividends. As such share price stays flat while cash is returned to investors as dividends. Using dividend discount model the company is worth more than just the share price alone.
There are other companies that may have depressed sentiment affecting their share price, or non blue chip companies that are great but undiscovered.
Not really a strong believer of emh, but you provided plenty of food of thought. Great post!
Hi INTJ
Agree with your sentiments.
If a company pays out almost 100% of their cashflow like reits then as investors we’d understand why that might happen.
The worst kind is if they are paying out a low payout, management have to utilise those cash on new opportunities that failed and balnce sheet gets weaker. I think could be considered a sad day for investors.
If share price will still same after 10 year so new traders will not invest in any shares because same price of share will not give any profit so the trader switch their investment in comex live gold price
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