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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