Long-Term Earnings Growth and Economic Growth (1)

Long-Term Earnings Growth and Economic Growth (1)

How do you value stock?

Stock prices are the present value of future dividends.

What are the determinants of stock prices?

These are earnings and dividends on a PER-SHARE basis.

Is economic growth an important factor influencing future dividends and hence stock prices?

Not necessarily. Although economic growth may influence AGGREGATE earnings and dividends favourably, economic growth does not necessarily increase the growth of per-share earnings or dividends. It is earnings per share (EPS) that is important to Wall Street because per-share data, not aggregate earnings or dividends, are the basis of investor returns.

What is the reason economic growth does not necessarily increases EPS?

Economic growth requires increased capital expenditures and this capital does not come freely. Implementing and upgrading technology requires substantial firm investment. These expenditures mus tbe funded either by borrowing in the debt market (through banks or trade credit or by selling bonds) or by floating new shares. The added interest costs and the dilution of profits that this funding involves place a burden on the firm's bottom line.

Can earnings increase without increasing capital expenditures?

Yes, in the short run, this may occur, but the long-run historical evidence suggests that it will not. One of the signal characteristics of long-term historical data is that the level of the capital stock - the total value of all physical capital such as factories and equipment, as well as intellectual capital, that has accumulated over time - has grown in proportion to the level of aggregate output. In other words, a 10% increase in output requires a 10% increase in the capital stock.

Will investment in productivity-enhancing technology spur earnings growth to permanently higher levels?

"Cost-saving investments" frequently touted as a source of increasing profit margins, only temporarily affect bottom-line earnings. As long as these investments are available to other firms, competition will force management to reduce product prices by the amount of the cost savings, and extra profits will quickly be competed away. In fact, capital expenditures often are undertaken not necessarily to ENHANCE profits but rather to PRESERVE profits when other firms have adopted competitive cost-saving measures.


Also read:
Long-Term Earnings Growth and Economic Growth (1)
Long-Term Earnings Growth and Economic Growth (2)