The Valuation Game
Read the valuation formula post for a more concise treatement using equations. But conceptually, the below should be the same. Without further ado,
A company’s share price appreciation comes from three sources:
(i) Lower expected rate of return for the same earnings. A 100$ recurring consistent quarterly earning is worth only $10,000 at 4% but is worth 40,000 at 1% returns. Of course real rates have not become this bad, but it has dropped preciptously in the last two decades to say 7% or so now, from above 12% in years past. But this earnings rate drop does not translate to a drop in market returns, as these income producting assets (stocks) have appreciated due to lower expected returns. So owners of stocks have bilssfully enjoyed price appreciation, but the future earning capacity of a set capital has now been greatly diminised. Theoretically, rising interest rates can turn the tide the other way. This does not seem to be in the cards due to reasons mentioned in the sixth and seventh blog posts in this series.
(ii) Earnings growth. A 100$ current quarterly earnings with 10$ yearly earnings growth upto 150$/quarter steady state is worth 10,000 currently but will be worth 15,000 in the future. So, the 5000$ gain would have a present value of say 3500$ if the rate of return is 4% again, for a total corporate value of $13,500. This only models a company which has 100$ earnings for a few years then suddenly jumps to 150$ quarterly earnings. To this amount, we need to add in the increased earnings of the ramp up for the couple years it takes to reach 150$. (the final answer will be less than 15000, since that’s the value of a company that makes 150$ in earnings today)
(iii) Earnings retention. If the company retains the earnings as cash (rather than paying out as dividends to the shareholders) then, the value of the company is not only its income generating value but also the amount of cash holdings, of course. For example, KO , the coca-cola company has a dividend payout of 75%, so it retains 25% of earnings which should increase the value of shares over time. (There are some other accounting rules w.r.t. depreciation and cash flow that could potentially make this case for appreciation even sweeter/richer, but this point is already valid as it stands)
Cars and Physics 