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How Falling Stock Prices Can Make You Rich

Part 1 of 2


Fountain pen and newspaper

Most people aren't rich because they'll spend twelve hours waiting in line for Christmas sales, saving money on televisions and computers, but won't use the same fervor to identify undervalued assets such as stocks, bonds, or apartment buildings.

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In general terms, there are three ways to make a profit from owning a business (buying stock is merely purchasing small parts of a business whereby you get these nice little certificates – depending on how many pieces of stock a company is divided into, each share will receive a certain portion of the profits and ownership).

  1. Cash dividends and share repurchases. These represent a portion of the underlying profit that management has decided to return to the owners.

  2. Growth in the underlying business operations, often facilitated by reinvesting earnings into capital expenditures or infusing debt or equity capital.

  3. Revaluation resulting in a change in the multiple Wall Street is willing to pay for every $1 in earnings.

An Example to Illustrate These Points

It may look complicated, but it’s really not. Imagine, for a moment, that you are the CEO and controlling shareholder of a fictional community bank called Phantom Financial Group (PFG). You generate profits of $5 million per year and the business is divided into 1.25 million shares of stock outstanding, entitling each of those shares to $4 of that profit ($5 million divided by 1.25 million shares = $4 earnings per share).

When you open a copy of the stock tables in your local newspaper, you notice that the recent stock price for PFG is $60 per share. This is a price-to-earnings ratio of 15. That is, for every $1 in profit, investors seem to be willing to pay $15 ($60 / $4 = 15 p/e ratio). The inverse, known as the earnings yield, is 6.67% (take 1 and divide it by the p/e ratio of 15 = 6.67). In practical terms, this means that if you were to think of PFG as an “equity bond” to borrow a phrase from Warren Buffett, you would earn 6.67% on your money before paying taxes on any dividends that you’d receive provided the business never grew.

Is that attractive? It depends on the interest rate of the United States Treasury bond, which is considered the “risk-free” rate because Congress can always just tax people or print money to wipe out those obligations (each has it’s problems, but the theory here is sound). If the 30-year Treasury yields 6%, why on earth would you accept only 0.67% more income for a stock that has lots of risks versus a bond that has none? This is where it gets interesting.

On one hand, if earnings were stagnant, it would be stupid to pay 15x profits in the current interest rate environment. But management is probably going to wake up every day and show up to the office to figure out how to grow profits. Remember that $5 million in net income that your company generated each year? Some of it might be used to expand operations by building new branches, purchasing rival banks, hiring more tellers to improve customer service, or running advertising on television. In that case, let’s say that you decided the divvy up the profit as follows:

$2,000,000 reinvested in the business for expansion: In this case, let’s say the bank has a 20% return on equity – very high but let’s go with it nonetheless. The $2,000,000 that got reinvested should therefore raise profits by $400,000 so that next year, they would come in at $5,400,000. That’s a growth rate of 8% for the company as a whole.

$1,500,00 paid out as cash dividends, amounting to $1.50 per share. So, if you owned 100 shares, for instance, you would receive $150 in the mail.

$1,500,000 used to repurchase stock. Remember that there are 1,250,000 shares of stock outstanding. Management goes to a specialty brokerage firm and they buy back 25,000 shares of their own stock at $60 per share for a total of $1.5 million and destroy it. It’s gone. No longer exists. The result is that now there are only 1,225,000 shares of common stock outstanding. In other words, each remaining share now represents roughly 2% more ownership in the business than it did previously. So, next year, when profits are $5,400,000 – an increase of 8% year over year – they will only be divided up among 1,225,000 shares making each one entitled to $4.41 in profit, an increase on a per share level of 10.25%. In other words, the actual profit for the owners on a per share basis grew faster than the company’s profits as a whole because they are being split up among fewer investors.

If you had used your $1.50 per share in cash dividends to buy more stock, you could have theoretically increased your total share ownership position by around 2% if you did it through a low-cost dividend reinvestment program or a broker that didn’t charge for the service. That, combined with the 10.25% increase in earnings per share, would result in 12.25% growth annually on that underlying investment. When viewed next to a 6% Treasury yield that is a fantastic bargain, so you might jump at such an opportunity.

Now, what happens if investors panic or grow too optimistic? Then the third item comes into play – revaluation resulting in a change in the multiple Wall Street is willing to pay for every $1 in earnings. If investors piled into shares of PFG because they thought the growth was going to be spectacular, the p/e may go to 20, resulting in a $80 per share price tag ($4 EPS x $20 = $80 per share). The $1.5 million used for cash dividends and the $1.5 million used for share repurchases wouldn’t have bought as much stock, so the investor is going to actually end up with less ownership because their shares are trading at a richer valuation. They make up for it in the capital gain they show – after all, they bought a stock for $60 and now it’s at $80 per share for a $20 profit.

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