At the time of this writing, the shares of the oil giant ExxonMobil trade at around $100 per share. The company pumps out $7.64 in total profits, and pays out $2.52 in dividends. When you buy a stock, there are three ways to turn a profit (again using Exxon as the illustrative example):
1. Valuation. This simply means that the investor community is willing to pay more for each $1 of profit than they were before. This is what has happened to ExxonMobil over the past three months. In the middle of October, Exxon was trading at $85 and pumping out roughly the same $7.64 in profits. Exxon is not 17% more profitable here in January 2014 than it was in October 2013, but rather, investors are valuing Exxon’s profits at a 17% higher rate.
2. Profits. In 2003, Exxon made $2.56 in profit. Now it makes $7.64. In the past 10-11 years, Exxon has increased the profits per share by a total rate of 198%. Although profits can and do fluctuate (especially for Exxon which is a commodities company where profits can be cyclical even for integrated oil companies), the profit base is much more “permanent” than the P/E multiple. For oil companies, you can expect profits to fall by 30% or so maybe two or three times in a generation. Otherwise, profits are a general march upwards. With the stock prices, you can see 30% differences between highs and lows every two or three years or so. Sustainable growth tends to trump changes in valuation brought about by P/E expansion.
3. Dividends. Even if ExxonMobil’s business never changed—it continued to pump out $7.64 in total profits and pay $2.52 in total dividends for ever, you would still receive $0.63 every ninety days for every share of Exxon that you own. Obviously, as profits increase, so does the dividend with a company of Exxon’s caliber. For the past three decades, the amount of money that Exxon has put in your pocket has increased. That has been the most predictably growing aspect of Exxon’s business. You cannot say that overall profits have gone up every year for thirty years, nor can you say that the stock price has increased every year since the early 1980s. The dividend has been the most consistently reliable source of wealth creation during the past thirty years. The other two components have not gone up in a linear fashion.
I broke it down into the three concrete components for an important reasons; it’s demonstrate why some people pursue growth at a reasonable price investing over value investing that often leads to you buying subpar companies. Sure, ideally, you’d make investments that combine all three companies; you’d find a company like Colgate-Palmolive, which almost always grows profits and dividends each year, trading at $40 per share so that you could financially benefit from P/E expansion as well.
But outside of 2008-2009 and 1973-1974 markets, you often find yourself having to choose: Do I go for the fairly valued company that is excellent, or the company that looks cheap and might be considered second-tier in terms of quality?
For me, I tend to favor the fairly valued excellent company. That is because I find items #2 and #3 on the list to be more important than item #1. When you find a company with a stable dividend, the benefits are automatic: within ninety days, you will be receiving the first of many cash payments that ought to continue for years to come. And when you identify a company with an economic engine that is steadily increasing profits, those gains are going to be more permanent than relying on shifts in the P/E ratio. All else equal, I’d rather double my investment by seeing profits at General Mills increase from $3 per share to $6 per share than seeing the P/E ratio increase from 15x earnings and 30x earnings. Real, honest-to-god profits are a much more reliable mechanism for building wealth than trying to make money solely due to the fact that other people are willing to pay more for a stock at a given time. P/E expansion is not a bad thing; it’s just more ephemeral. General Mills doesn’t regularly see its profits decline by 20%, but stock price declines by 20% are simply a regular hazard of the marketplace.
It all comes down to what kind of investor you want to be. There is nothing wrong with buying stocks with P/E ratios of 8 and selling them when they hit 12x earnings. A lot of that stuff is the foundation of Benjamin Graham’s life work, and there is a lot of wisdom in finding a “margin of safety” in terms of the price that you pay. But if you have the orientation that you want to buy stocks today and still be holding them in 2035, then a first priority focus on valuation isn’t going to be your game. You’re going to want to focus on companies with records of paying out dividends for generations and growing profits for generations, because those are much more permanent ways to increase wealth than relying on changes in P/E ratios of stocks.
Originally posted 2014-07-16 07:17:16.