So, We Ask

Not all retained earning is reinvested in the company. A company may decide to maintain part of it as highly liquid cash equivalents. Or, some companies simply may decide to buy half dozen airplanes to ferry their executives on the weekends to their homes in Bahamas or wherever and back. Just kidding!! The point is the practice of investing in itself is necessary to maintain or increase productivity. Therefore, whatever portion of the retained earning that is reinvested into the company should result in a measurable increase in the market value of the company. The range of this increase varies from company to company. Some companies are more able than others in this regard. Let us assume that a company has established an old habit of converting the retained earning into corresponding market value of equal proportion, assuming that the number of outstanding shares remains unchanged. Then, by expressing the retained earning as a percentage of the market value, we find the percent increase in the size of the market value of the company. Therefore, an investor in the said company can expect to see his investment grow by the same percentage in the future. Let us say, this figure is 10 percent. Now then, an investor who desires a return of 15 percent would not meet his expectation by investing in such a company unless he buys the stock at an appropriate discount. At this point, one asks, “Is the stock price cheap, fair or expensive?” To find an answer to this question, one needs to find the intrinsic value of the company. The intrinsic value is calculated using “Dividend Discount Model.” It is a theoretical value obtained using very highly probable assumptions. A comparison between intrinsic value and the actual market value gives you an answer to the question asked above. Robert Hagstrom Jr.’s book (I bought a previously-enjoyed copy of this book for C$6.00 from amazon.com) very ably describes how to derive a company intrinsic value. There are other numbers which are also important indicators of company health and prosperity. I will deal with them, one at a time, in the days to come. Knowledge is the intrinsic value. Application of knowledge is the real thing.