Return on Capital
Return on capital is a measure of a company's profitability.
Return on Capital = Profit / Invested Capital
Return on Stock
Return on stock represents a combination of dividends and increases in the stock price (capital gains).
Stockholder Total Return = Capital Gains + Dividends
The important relationship between Return on Capital and Return on Stock
The market frequently forgets the important relationship between return on capital and return on stock.
A company can earn a high return on capital, but the shareholders could still suffer if the market price of the stock decreases over the same period.
Similarly, a terrible company with a low return on capital may see its stock price increase
Short run
In the short term, there can be a disconnect between
This is because a stock's market price is a function of the market's perception of the value of the future profits a company can create.
Sometimes this perception is spot on; sometimes it is way off the mark.
Long run
But over a longer period of time, the market tends to get it right, and the performance of a company's stock will mirror the performance of the underlying business.
The Voting and Weighing Machines
The father of value investing, Benjamin Graham, explained this concept by saying that in the short run, the market is like a voting machine - tallying which firms are popular and unpopular. But in the long run, the market is like a weighing machine - assessing the substance of a company.
Message
What matters in the long run is a company's actual underlying business performance and not the investing public's fickle opinion about its prospects in the short run.
Return on capital is a measure of a company's profitability.
Return on Capital = Profit / Invested Capital
Return on Stock
Return on stock represents a combination of dividends and increases in the stock price (capital gains).
Stockholder Total Return = Capital Gains + Dividends
The important relationship between Return on Capital and Return on Stock
The market frequently forgets the important relationship between return on capital and return on stock.
A company can earn a high return on capital, but the shareholders could still suffer if the market price of the stock decreases over the same period.
Similarly, a terrible company with a low return on capital may see its stock price increase
- if the firm performed less terribly than the market had expected, or,
- maybe the company is currently losing lots of money, but investors have bid up its stock in anticipation of future profits.
Short run
In the short term, there can be a disconnect between
- how a company performs and
- how its stock performs.
This is because a stock's market price is a function of the market's perception of the value of the future profits a company can create.
Sometimes this perception is spot on; sometimes it is way off the mark.
Long run
But over a longer period of time, the market tends to get it right, and the performance of a company's stock will mirror the performance of the underlying business.
The Voting and Weighing Machines
The father of value investing, Benjamin Graham, explained this concept by saying that in the short run, the market is like a voting machine - tallying which firms are popular and unpopular. But in the long run, the market is like a weighing machine - assessing the substance of a company.
Message
What matters in the long run is a company's actual underlying business performance and not the investing public's fickle opinion about its prospects in the short run.
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