Introduction
Many small investors and stock market traders misunderstand what they are actually investing in.
They are buying shares in a business. The primary objective of a business is to make money and deliver an acceptable Return On Investment (ROI) to the business owners.
Business profits for public companies on the stock exchanges are reported as Earnings. The focus of this report is to explain why Earnings are the driving force and the main indicator of stock market trends.
First, let's go back to the history of companies and why people invest in shares.
Why Were Companies Invented?
Companies were invented in the Dutch Republic (now the Netherlands) around 1600.
At that time, Dutch merchants were sending ships to the Spice Islands (modern-day Indonesia) to buy spices and sell them back in Europe for a big profit.
Ships were at high risk of sinking or being taken by pirates. To spread the risk, the company entity was invented. This was called a Joint Stock Company, and it allowed a group of people to invest in the venture by purchasing shares. Profits were distributed in proportion to shares held. Shares could also be on-sold to anyone, at any time, at a negotiated price.
The Amsterdam Stock Exchange was set up in 1602 to enable trading in company shares.
The Purpose of the First Companies
The sale of shares raised money (Guilders or Florins at the time) to:
- ›Purchase a ship and equipment
- ›Employ a crew for the 12 months or so the venture would take
- ›Buy provisions for the crew
- ›Purchase goods to trade for spices in the Spice Islands
- ›Run the company, including liquidation at the end of the venture
On return to the Dutch Republic, the spices and other goods were sold. The ship and all equipment were also sold, and all assets liquidated.
The net profit was paid to shareholders as a Dividend.
It was quite common for the net profit to deliver a Return On Investment of over 500%.
Example: A Dutch Shipping Venture
Initial Public Offering
The ABC Spices Company was established with 1,000 shares. The funds to be raised from the sale of shares were based on:
| Item | Amount |
|---|---|
| Buy ship and equipment | $1,000,000 |
| Employ captain and crew for 12 months | $100,000 |
| Food and supplies for the crew for 12 months | $100,000 |
| Goods to trade (tools, cooking equipment and utensils, and a wide range of cheap manufactured goods) | $100,000 |
| Company administration and management, including liquidation at the end of the venture | $50,000 |
| Other | $50,000 |
| TOTAL | $1,400,000 |
Initial share price = $1,400,000 / 1,000 shares = $1,400 per share
Estimated Earnings
Spices from the Spice Islands were in huge demand throughout Europe. The most profitable included nutmeg, cloves and mace. The markup could be up to 1,000% in the early 1600s.
Typical sale proceeds and profit at the end of a venture:
| Item | Amount |
|---|---|
| Expected net proceeds from the sale of spices at a 500% markup | $7,000,000 |
| Sale of ship and equipment | $100,000 |
| Total proceeds | $7,100,000 |
| Less initial investment | -$1,400,000 |
| NET PROFIT | $5,700,000 |
The estimated net profit of $5,700,000 is the Earnings.
Earnings Per Share (EPS) = $5,700,000 / 1,000 shares = $5,700 per share
Return On Investment
ROI as a percentage of the initial investment:
= $5,700 / $1,400
= 407%
This was the ultimate objective of investing in shares in the 1600s: to make a huge business profit.
It is still the fundamental basis for buying shares in a business today: the expectation of business profits at a level that is acceptable relative to the risk.
Price to Earnings Ratio (PE)
When the initial shares were traded, the Price to Earnings ratio was based on the Earnings estimate:
= $1,400 / $5,700
= 0.25
The PE was 0.25 at the start of the venture.
Speculation and Share Trading
ABC Spices might start trading at the IPO price of $1,400.
An investor, WilyXYZ, may consider an ROI of over 400% so high that they would accept perhaps a 200% ROI. This means WilyXYZ might offer up to $2,800 for a share.
Accepting a lower ROI relative to risk, and paying a higher price for a share, is the basis of share trading. If ABC Spices was 10 months into the venture, the risk of failure would be much lower than at the start, so the share price at that time would likely be higher to reflect the lower risk.
Equally, a shipwreck would wipe out the company entirely, and the share price would crash to zero.
Over time, bigger companies were set up that spread their risk by having multiple ships trading in different markets at different times.
Investors gradually accepted a lower ROI as companies became more reliable at delivering consistent profits.
Should You Dial Down the Risk and Control Your Losses?
Why UIS Risk Ratings Are Your Trading Insurance
Since 1997, the UIS Risk Ratings have correctly identified 100% of Bear and Big Bear crashes, in advance of them occurring.
How to Predict Stock Market Crashes
Sample UIS Risk Rating Report