Hello readers! This article is not so much about finance than it is economics, just to let you know. This post is mainly addressed to my friends and investors that are waiting to buy shares only at the 'previous crisis' prices, be it 2008 global financial crisis, the great depression era etc. Many people I know are spooked by high prices right now compared to say 10 years ago, especially my parents. ;) While the concept of this discussion might be subject to some controversy because 'things are not that simple', I believe this basic concept will definitely apply no matter what time or place you are, to different extents.
First of all, I am fairly sure everyone more or less grasp the concept of inflation. It is a inevitable phenomenon that erodes the purchasing power of our money over time. I remember buying plain pratas at 50 cents about 13 years ago, back in primary school. Right now the cheapest I could find is $1.10 (the 10 cents was added rather recently, to my further dismay). Over 13 years, this would mean a price compounding of about 6.25% annually. While in reality I doubt there are as many products who rose in prices as fast as this, just take note of this as an example.
That leads us to our second point. Would you still, logically, expect plain pratas to cost 50 cent anytime soon, such as next year, 5 years later, or even 10 years later? It would take a miracle or a insane prata seller to make that happen anytime from now. I am fairly confident when I say that the average price of pratas will never hit 50 cents anytime from today onward, assuming everything goes as per normal. If you are one of those who would find reasons to rebut this statement, such as the world might fall into ruins or maybe 90% of all the money the world disappeared overnight etc., just know that I totally agree with you and I also suggest you exit this page immediately.
Moving on, lets say a similar product is produced by CURRY CO., we shall call it CCO. CCO sells pratas at 50 cent 13 years ago. The cost price, taking into consideration the dough, manpower, utilities etc. comes up to about 25 cent per prata. This allowed CCO to make a profit of 25 cent per piece of prata sold.
Because of inflation, the seller supplying the flour to produce the dough increases price by 5% year on year (y.o.y), the rest of the suppliers - utilities, manpower salaries, rental - follows suit. This would result in total costs of producing the prata to increase by 5%. The company then decides to adjust for this by increasing prices by 5% as well. A year later, the new cost of a piece of prata is now 52.5 cents, while the cost to produce it is 26.25 cents. This would result in a profit of 26.25 cents, versus the previous profit of 25 cents per prata. Fast forward 10 years, the cost of a prata would be 81.44 cents, while the cost to produce it would be 40.72 cents, resulting in a profit of 40.72 cents.
As you can see, technically the company did not gouge customers by raising prices more than it need to, but profits rose 5% y.o.y as sales and costs also rose 5% y.o.y. Sure, one can argue that the company can only raise prices enough to maintain the initial 25 cents profit. However if a company does that then it clearly has incompetent short-sighted management and that company will definitely not last long.
Now that we are all on the idea of companies profits will simply rise along with inflation if all else remains same, let's talk about share prices.
Lets go back to CCO 10 years ago. The company sells 10 million pratas that year, that would mean a profit of $2.5m for the year, with 25 cents of profit per prata. The management then decide to distribute 10% of earnings as dividends. Assuming 100,000 shares in circulation, that would result in a distribution of $2.50 per share. Given an average yield of 4% dividend on generic equities, that would mean a share price of $62.50.
Then comes an financial crisis, share price plummeted across the globe, with CCO share price falling about 50% to $30 per share. This resulted in yields of 8.33% (this is no exaggeration , yields were seen reaching ~10% in the 2008 financial crisis). Sales then continued as usual, people still have to eat right? As mentioned earlier, 10 years later - now, profit per prata is at 40.72 cents. All else remaining equal, total distribution per year would be $407.2k.
The company still distribute 10% of their earnings to 100,000 shares. Each share now has a distribution of $4.072. The economy is now healthy with a dividend yield of 4% again, this would mean a current share price of $101.80.
Let's say you're an investor and you look at the historical price chart of CCO. Definitely you would want to buy the stock when it was at $30 during the financial crisis, or you might want to buy the stock only when it is selling at the average price 10 years ago at $62.50. After going through all the above, does this rationale still make sense to you?
A price of $30 with current profits/distribution would mean a yield of 13.57%, while at $62.50 the yield is 6.5152%. While the latter if plausible during a financial crisis, you are just buying the stock at a face value of $62.50, while the intrinsic value of the stock has already risen much more than that. It means that even if the price is the same, the stock - and the various factors along with it - is already different.
If as an investor, one plainly looks at prices to decide the value of the stock, then you have already missed the axiom of inflation and the value of money. In the case of CCO, you might have missed the '$30 boat', but assuming yields of 8.33% for a DPU of $4.072, a price of $48.80 is exactly the same as the '$30 boat'.
The points brought up by this discussion might come as common sense to many, such as inflation etc. but the amount of people who misses the big picture is still astoundingly high. So I hope long-term investors would digest this discussion and don't be so hard up with your money, lest you miss more future 'boats'.
Happy investing!
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