The returns of investing in an individual stock or in the entire stock market are determined by these three factors:
The Sources of Investment
1. Business growth
If we look at a particular business, the value of the business is determined by how much money this business can make. The growth in the value of the business comes from the growth of the earnings of the business growth. This growth in the business value is reflected as the price appreciation of the company stock if the market recognizes the value, which it does, eventually.
If we look at the overall economy, the growth in the value of the entire stock market comes from the growth of corporate earnings. As we discussed above, over the long term, corporate earnings grow as fast as the economy itself.
Dividends are an important portion of the investment return. Dividends come from the cash earning of a business. Everything equal, a higher dividend payout ratio, in principle, should result in a lower growth rate. Therefore, if a company pays out dividends while still growing earnings, the dividend is an additional return for the shareholders besides the appreciation of the business value.
3. Change in the market valuation
Although the value of a business does not change overnight, its stock price often does. The market valuation is usually measured by the well-known ratios such as P/E, P/S, P/B etc. These ratios can be applied to individual businesses, as well as the overall market. The ratio warren buffet uses for market valuation, TMC/GNP, is equivalent to the P/S ratio of the economy.
When that seductive fellow Mr. Market comes around, you have to pay absolutely no attention to him, no matter what happens. You have to control your emotions, and most of the time that means the best thing to do is nothing. If you can’t control your emotions, being in the market is like walking into a heated area wearing a backpack full of explosives.