COMPANY PROFITS VS. INVESTOR PROFITSSubmitted by Retire Source Wealth Management on June 21st, 2022
A company's profits largely depend on the difference between what it costs a company to create its goods or services and what it charges its customers. For example, General Motors (GM) will make a $5,000 profit if it sells a car for $35,000 that costs $30,000 in material, labor, etc. Clearly, the larger the profit per car the better for GM. On the other hand, investors in GM stock only profit if and when the stock price increases from their purchase date.
So one might wonder if higher company level profits from selling cars directly translates to higher investor level profits from rising stock prices? In practice there is no direct financial link between the two. For example, in 2020 GM company profits dropped about 5% (they sold less cars), but GM stock price increased about 15%. In that year company profits fell while investors profits rose. While there is no direct link, there is a theoretical indirect link that I believe holds up well over the long term. On an aggregate level all the stock investors in GM own the entire company, and therefore own all the company's profits. From an accounting level more company profits translates to a more valuable company. Eventually, if GM continues reporting increasing company profits, it will create favorable attention with new investors, which will in turn push up the stock price.
In any given year, there's always a lot of things that can distort the linking of company and investor profits. For example, investors emotional appetite for risk sometimes spikes, creating an out-sized desire to buy and hold stocks.
Historically, market bubbles are often marked by emotions, optimism, and speculation crowding out the calculated, rational analysis of a company's financial reports and its capacity to earn a profit.
Back in 1999 we saw the dot-com bubble driven by investor enthusiasm for all things internet. Wild investor optimism caused the technology-laden NASDAQ composite index to double in about a year. It then spent the next year giving up all of those gains and trended down for years to come. The fact that at a company level many of those dot-com businesses could not earn a profit was lost on many investors... until it wasn't.
In 2020 things like stimulus checks, social media hype, new technologies/industries, and near zero interest rates made many investors significantly more aggressive. At the same time traditional investment research was increasingly ignored. Boring stuff like analyzing a company's capacity to earn a profit from selling its good or service was increasingly ignored, and even denigrated as outdated and out of touch. New money flowed into investment themes like cannabis, electric vehicles, social media, online retailers, and meme stocks. Once again many of these companies were part of the NASDAQ index. Last year that index was up about 23%. So far this year (as of 6/13/22) the index is down around 30%. What happened? We can blame inflation, war, supply chain problems, labor shortages, etc. One common theme is these factors all have a potential negative affect on the economy, and by correlation company level profits. As in 1999, company level profits didn't matter to investors...until they did. Stay focused on company profits. I'll take a boring profitable company over an exciting unprofitable company any day.
Frank Rizzo, CERTIFIED FINANCIAL PLANNER TM
The opinions in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. The economic and market forecasts set forth in this material may not develop as predicted and there can be no guarantee that strategies promoted will be successful. Investing includes costs and risks, including fluctuating prices and loss of principal. Historical performance is no guarantee of future results. Investors cannot invest directly in the NASDAQ index.