How does investing work?

Question

How does your money grow? How does stocks work? When a company makes a million how much do you make?

Answer 1

You are acquainted, young boss, with the effect of the income statement on the balance sheet. As the company equity grows or shrinks from profits or losses, that affects the intrinsic book value of the company. Those profits or losses also affect the valuative processes of the company's stock (assuming a publicly traded company). When the market compares the value of this company with the industry and the market in general, they usually assign (by way of trading bids and offers) a compatible Price to Earnings. If you were highly speculative but still favored, perhaps for your future prospects, you might have some price stability with a high P/E. If you had an old, mature company its valuation would be at a smaller, less speculative P/E. If your company made a million and there were only a million shares, then that would be $1 per share. If your company traded as an old company commonly earning this, then you might see a price of around $10-15 (P/E of 10-15). If you were more speculative, yet actively traded, you might have a P/E of say 80 or 90 if you hadn't been making this profit but suddenly did. But something else comes into play. What is your equity, your book value? A company with a 100 million shares, making only $1 million in profit, that is but 1 cent per share. The market may not be interested. If the equity for that company were $100 million, that too would look pretty pathetic ($1 per share, earning 1 cent per share), but if your book value were closer to say $10 million, that 100 million shares would put the book value at 10 cents per share--earning 1 cent per share is pretty good, so emails will go out from spammers telling about this little company that will be worth $20 a share in weeks! When the dust settles from the hype, the market will again, by bids and offers, hover at some appropriate P/E for a 10 cent company earning a penny.

I just looked at JCP a little while ago. It had earnings of $477 million in the last quarter, down from $551 million at the same time last year. They have an earnings of $2.09 a share, but something like 224 million shares. The difference between the $2.34 per share earnings last year and the $2.09 per share this year sent people trading the stock some $2.78 lower. Penney's P/E is about 17.88, which is about 86 percent of the average for the industry. If the company had done the opposite, instead of making $477 million, they made $551 million, then people would have wanted to bid up the stock to reflect the improved value. That is how it works.