“It has been asserted that investors today are paying higher prices for stocks on the basis of current profits than they were in the past. This is because, although equity prices rose rapidly in the latter stages of a market cycle, investors increased their demand for profits from those stocks without giving equal consideration to future potential.”
One fundamental question we will speak about within this blog post is “are investors really paying more for profits than growth?” We will first discuss what determines whether or not this is true. Then we’ll explore who might be responsible for such a phenomenon and why they may have done so. Finally, we’ll consider what implications are present when some investors do pay more attention to profit levels in addition to growth plans.
“When a stock is first introduced to the market, its price will tend to be low. Investors will thus be interested in purchasing it at a low price and holding it for a long time in an attempt to increase their holdings without incurring any of their costs.” “The value of the stock thus comes from the expected return on investment, which is equal to the future discounted present value of capital gains (or losses), including both realized and anticipated capital gains through payment of dividends.”
This quote from Investopedia is largely correct. Larger companies tend to have higher profit margins, lower sales and earnings growth, and a longer life cycle than smaller companies so they can afford to pay investors more for their profits.
“For example, in the 2000-2003 bear market, average stock prices declined by -3%, but average return on equity fell by -14% (Blue & Shleifer 2005).”
This point is mostly correct as well. The most important benefit of acquiring larger corporations is we can be relatively certain the company will continue to have a positive return on equity for many years into the future.
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