Good morning & happy Monday!
“Business must be run at a profit, else it will die. But when anyone tries to run a business solely for profit, then also the business must die, for it no longer has a reason for existence.”
– Henry Ford, founder of Ford Motor Company
Today I would like to go to the very basic level of business.
What is the purpose of business? Why does a business exist? What do businesses do?
Every business was formed for and exists for one main reason: to make a profit.
When a business ceases to make a profit and does not have a path towards profitability it no longer is a business (think Sears, K-Mart, etc.).
Every investor has one primary objective as well, and it is exactly the same … to make a profit.
Now, in the pursuit of making a profit all sorts of good things develop that you and I benefit from every single day. The pursuit of profit has resulted in diseases being cured, mind-blowing technological advances being made, and progress mankind has experienced that would not have ever occurred if it were not for profit-seeking corporations.
For all the corporate bashing that I hear in the media and from our politicians I will proudly stand up for business and profit-making. (There are plenty of examples and exceptions, but overall, I love business!)
Making a profit is not only not a bad thing, I contend that it is a wonderful thing.
What is so great about investing is that you and I are provided with an opportunity to be amongst those benefiting from the profits publicly traded corporations generate. In other words, we can profit when the companies we own profit. How cool is that? (Nerd alert, I get super excited about this stuff! 😊)
Now, when it comes to equity (stock) investing I want to address the concept of what you get and what you pay.
What you pay is the stock price. What you get is an ownership stake in the company purchased.
To make this as simple as I can, let’s hypothetically say that Intentional Wealth was a publicly traded company with a value of $1,000,000. Let’s say that there are 10,000 shares issued, that would mean that each share would have a value of $100 (10,000 shares x $100 per share = $1,000,000 value). Let’s also assume for this example that Intentional Wealth currently makes a profit of $50,000/year and that the profits grow by 5% per year. (All of these figures are completely made up and Intentional Wealth is not a publicly traded company).
Now, if you purchased 10 shares of Intentional Wealth you would pay $1,000 (10 shares x $100 per share = $1,000 investment). That is your cost.
What do you get in exchange for that $1,000 investment? 10 ownership shares of Intentional Wealth … in this example that represents a 0.10% ownership stake in the company.
Now, there are 2 different ways in which you would potentially profit from this ownership stake.
- Dividends
- Share value growth
Dividends: If the profits of Intentional Wealth are $50,000/year and you own 0.10% of Intentional Wealth then you would receive $50/year in dividends ($50,000 profit x 0.10% ownership stake = $50 annual dividend).
Now, over time does Intentional Wealth want to increase or decrease its profits? Of course, the objective of the business is to increase profits, that is the objective of every business. In this hypothetical example, the more the profits of Intentional Wealth grow, the more you will benefit from the increase in dividends paid out to you as a partial owner of the company.
As mentioned above, we will assume that the profits grow by 5% in this example. Here’s a table of the dividends pay out each year:
| Year | Annual company profits @ 5% growth rate Rounded to the nearest full dollar | Annual dividend paid for a 0.10% ownership stake Rounded to the nearest penny |
| 1 | $50,000 | $50 |
| 2 | $52,500 | $52.50 |
| 3 | $55,125 | $55.13 |
| 4 | $57,881 | $57.88 |
| 5 | $60,775 | $60.78 |
| 6 | $63,814 | $63.84 |
| 7 | $67,004 | $67.00 |
| 8 | $70,355 | $70.36 |
| 9 | $73,873 | $73.87 |
| 10 | $77,566 | $77.57 |
| 11 | $81,444 | $81.44 |
| 12 | $85,517 | $85.52 |
| 13 | $89,792 | $89.79 |
| 14 | $94,282 | $94.28 |
| 15 | $98,997 | $99.00 |
| 16 | $103,946 | $103.95 |
| 17 | $109,144 | $109.14 |
| 18 | $114,601 | $114.60 |
| 19 | $120,331 | $120.33 |
| 20 | $126,347 | $126.35 |
| TOTAL | $1,653,294 | $1,653.33 |
So, in this example company profits grew over 20 years from $50,000 to $126,347 … and total profits over that 20-year period of time were $1,653,294.
That means that as a 0.10% owner (your 10 shares) you would have received $1,653.33 in dividends over the 20 year period of time (remember, your original cost of purchasing a 0.10% stake in the business was $1,000) and you still maintain the ownership in the business that you could sell or continue to collect the dividends from.
Share value growth: If Intentional Wealth continues to grow its profits, is the company going to be more valuable or less valuable? Of course, it should be worth more.
As the chart above illustrates, if the profits grow from $50,000/year to $126,347/year 20 years later (roughly 250% growth) we could reasonably assume the value of the business would be worth 250% more as well. That would put the value of Intentional Wealth at $2,500,000 instead of $1,000,000.
Based on that assumption, as a 0.10% owner you would be able to sell your ownership stake to someone else for $2,500.
So … when we take a look at both of those factors, we would see a $1,000 investment into a business paid $1,653.33 in dividends over 20 years and then the ability to sell that ownership stake for $2,500 in 20 years. That means the total value of your investment was $4,153.33. You turned $1,000 into $4,153.33!
Price is what you pay, value is what you get.
Of course price matters, it matters a lot. You never want to overpay for an ownership stake in a business (or anything for that matter), but I never what to lose track of what you get when you invest … you get the amazing ability to take an ownership stake in some of the best run, most profitable companies every created. That ownership stake entitles you to share in the profits (dividends) and share in the growth of the company (share value growth).
If you take an ownership stake in a company for $10 per share and a month later the company stock price is $9.50 I would contend it does not really matter. You still have the same ownership stake in the same company and still can benefit from the profits of that ownership stake (dividends, future share value growth). If it is a well-run, profitable company the temporary reduction in stock price just creates an opportunity for you to potentially take a greater ownership stake at a lower price, it does not mean it was a bad investment at $10 per share.
If you’re waiting for the stock price to drop to $9.00 a share that may never happen and you may miss out on an opportunity to take an ownership stake in a great company, or you may have to pay $11 or $12 to acquire an ownership stake at a future point because you were waiting for a $9 share price that never happened.
Pay a fair price for an ownership stake in a diversified group of high-quality companies and then let the companies do their thing … make a profit! 😊
This is far more complicated than I have outlined here, we are really only scratching the surface, but I think I probably have already overdone it for today. 😊 I’ll probably use next week’s memo to address this a little bit further as there are some really valuable concepts to grasp within this arena.
As always, please never hesitate to reach out to discuss further any of the topics I bring up in these weekly memos.
Hope it is a productive and profitable week ahead!