Why Stocks Rise,
Part 3
Earnings, earnings, earnings

by Ann Coleman (TMF

Reston, VA (January 27, 1999) -- Once upon a time, an embarrassingly short time ago, actually, I believed that if a stock didn't pay dividends, then the only reason anyone bought it was essentially the greater fool theory. People bought non-dividend paying stocks because they thought some other fool (small f) would pay more for the company later -- even if it still wasn't paying dividends.

I thought that because I misunderstood the nature of investing. When you invest in a company, you are a part owner of that company. If you think through the implications of that, many misconceptions go away.

I've found that it helps to imagine a very small company. In essential ways, company ownership is the same whether you own half of a lemon-aid stand or 100 shares of General Electric (NYSE: GE). Those one hundred shares, by the way, would represent ownership of approximately 3 one millionths of GE. If you bought 100 shares of GE because you thought that the company was popular and always goes up, you entirely missed the point.

GE's three and a quarter billion shares is a bit hard to get your mind around, so let's think about Jim-Bob's Lawn Service. Jim and Bob started their lawn service when they were both 15. Each put up $200 to buy two used mowers, some business cards, and flyers. They worked hard and developed a steady clientele and by the time they got out of high school, they owned 6 mowers and had 10 friends who worked for them part time. Jim went off to college "back East" with dreams of Harvard Business School, and Bob went to the local community college. Before he left, Jim incorporated the business with himself and Bob as the only two shareholders.

As a corporation, Bob kept books and paid himself a generous salary instead of just splitting the cash with Jim like he used to do. At the end of each year, when Jim was home for Christmas break, they both went over the books and figured out how much profit the corporation had made. When Bob suggested that they split what was left over like they used to do, Jim always said the same thing: Why not buy more mowers (trucks, fertilizer spreaders, cell phones), etc. instead?

By the time Jim got out of Harvard Business School, the Jim-Bob Lawn Service was the biggest in town. (The fact that their employees were mostly local college students who thought of their jobs as akin to a workout in the gym and who tended to work in Lycra hadn't hurt their growth rate at all.) While Jim hadn't received a penny in profits since the company was incorporated, Bob had made an excellent living for himself. Now, however, Bob is thinking about getting married and going back to school. Together, he and Jim decide the time has come to sell the business. Lawn Chemicals R US buys the company for $500,0000. Bob gets half. Jim gets half.

When earnings are not paid out to shareholders in the form of dividends, a good management team can use them to help a business grow faster. This increases the intrinsic value of the business. Ultimately, a well-run business will get to the point where it is making more money than it can reinvest in itself. At that point, the owners (meaning shareholders) may decide that the best use of that money would be to split it among the owners. Or they may decide that those profits would be better spent in buying back some of the shares outstanding, thus increasing the value of their own shares.

(Think small, again -- say a company is owned by 10 people who each own 10% of the shares. If the owners decide that instead paying themselves dividends, the company should use its profits to buy out two shareholders, each remaining shareholder would then own 12.5% of the company. When dividends are paid or the company is sold, the profits only have to be split 8 ways instead of 10.)

That's why earnings are more important than dividends. Earnings can become dividends or they can be used to increase the intrinsic value of a business.

Now, Foolish Four investors like dividends. We are investing in companies that have gone way beyond their fast growth stage -- mature companies that share their earnings among the companies' owners. Many investors buy stocks for those dividends. (Bless 'em.)

Obviously, if earnings are threatened, the company's ability to pay dividends may be in jeopardy. But beyond that, if earnings are disappointing, even by a few cents per share, the company's long-term ability to reinvest in itself is also threatened. That's why anything that threatens earnings can translate immediately into a lower price and anything that looks good for earnings can translate into a higher price -- even though the news may not ever affect dividends.

Friday: How much are investors willing to pay for earnings?

Fool on and prosper!

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Today's Stock Lists | 1998 Dow Returns

01/27/99 Close
Stock  Change   Last
CAT  -   1/2   44.63
JPM  -3  3/4   100.50
MMM  -1 13/16  74.19
IP   -1 15/16  40.88
                   Day   Month    Year   History
        FOOL-4   -2.80%  -2.90%  -2.90%  -1.46%
        DJIA     -1.33%   0.20%   0.20%  -0.19%
        S&P 500  -0.73%   1.14%   1.14%   2.53%
        NASDAQ   -1.08%   9.78%   9.78%  11.29%

    Rec'd   #  Security     In At       Now    Change

 12/24/98   24 Caterpillar   43.08     44.63     3.59%
 12/24/98   14 3M            73.57     74.19     0.84%
 12/24/98    9 JP Morgan    105.51    100.50    -4.75%
 12/24/98   22 Int'l Paper   43.55     40.88    -6.14%

    Rec'd   #  Security     In At     Value    Change

 12/24/98   24 Caterpillar 1034.00   1071.00    $37.00
 12/24/98   14 3M          1030.00   1038.63     $8.63
 12/24/98    9 JP Morgan    949.62    904.50   -$45.12
 12/24/98   22 Int'l Paper  958.12    899.25   -$58.87

                             Cash     $28.26
                            TOTAL   $3941.64