The very initial phase
I like to start a blog post with the very fundamentals because the simpler your ideas, the easier it is to get started. Feel free to skip down lower if this is too obvious. So what are shares and what do companies do? Companies make money by engaging in business activities and they are owned by people. In the case of public companies, anybody can own a share or piece of the company by buying a unit stock or more.
The captial to conduct business and inventory (if needed) comes from either:
(a) Investment from people, who fund the business in exhange for new or increased ownership
(b) Debt, borrowed against the company’s assets/reputation
In this blog we’ll be mostly discussing public companies. Stock market trading does not yield the company any capital, as simply the old owners and new owners of the company are trading ownership stakes in the company. The firm only raises money in a new equity offering or on the initial sale of stock.
The Modern Economy
Once we have estabilshed that companies exist to make money for owners by serving clients, we come to the earnings history and cycle of the public companies traded on the modern stock exchange. This is usually done on a quarterly cycle that lines up with the calendar year. Modern trading is much better due to being electronic and algorthmic, with liquidity and price determination driven both by volume of stock of the big companies and by instant matching of bid-ask between buyers and sellers by the computers.
The value of a company stems from its ability to make money in the long term. The recurring nature of consistent or increasing earnings is key, not just profitability itself. So, the value of a company based on a set earning is determined by (dividing by) the total return rate. The total return rate is the sum of the inflation rate plus the market rate of return plus the risk-reward rate of return for that company. For the purposes of this post, let’s consider stable medium cap and large cap established companies that have relativiely low risk of bankruptcy or heavy capital loss, so the primary driver is the (inflation adjusted) market rate of return.
Let’s say a company makes 100$ a quarter in profit. Then the question one needs to aks oneself is what amount of money can generate this return. In modern economies, growth is releatively low and ordinately inflation tends to be low. This also drives interest rates to be low as well.
So continuing with our numbers finally, the 1% annual inflation rate and a 100$ quarterly earnings would imply the company is worth $40,000, if the competing market had zero productivity and only held on to inventory or commodities that kept pace with inflation. Of course this is with zero risk and zero actual market return, so we might see trading prices in the market closer to $10,000 for this company, with a 4% total return. This is known as a discounted cash flow model and is not the subject of this blog post. Rather the details of value fluctuations under macro-conditions are of interest here.
The role of debt and leverage in valuation
The ratio of the debt to the equity investment a company has raised by selling ownership interests is called the leverage ratio and is an improtant facor in risk multiplication, as a rule of thumb. (Risk being defined as a chance of company bankruptcy under adverse performance, with higher leverage being more high risk/high reward)
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