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How Corporate Profits and Dividends Affect Investor Returns

 

 

 

 

How Corporate Profits and Dividends Affect Investor Returns

 

November 28, 2023

 

 

Audrey Keel | Marketing Manager

 

 

 

The stock market has been supported by a healthier-than-expected economy this year, generating returns that have helped many​​ portfolios to partially recover from last year's bear market. Investors now hope these growth trends will translate into stronger corporate earnings since, in the long run, markets tend to follow the same trajectory as profits. With the future of the economy still uncertain, what signs are there that companies might begin to see improved profitability?

The third quarter earnings season is wrapping up with 94% of S&P 500 companies reporting their results. According to FactSet, 82% of these companies have had positive earnings surprises, yielding an expected year-over-year earnings-per-share growth rate of 4.3%. This is likely to be the first quarter of positive growth in a year, a notable inflection point that mirrors the surprising stability of the underlying economy. Consensus Wall Street estimates are for earnings to be flat this year at about $217 per share but to then rebound in 2024 by 11%. While this is somewhat at odds with economic forecasts for slowing growth in the coming quarters, it's safe to say that any acceleration in earnings would be welcomed by investors.

Earnings growth may have reached an inflection point

As the accompanying chart shows, the growth of corporate profits has been slowing since its peak in 2021, but may have reached a​​ turning point. Historically, large public companies have increased their earnings by an average of 7.7% per year, but this fluctuates alongside the business cycle. To oversimplify the earnings cycle, in good times companies increase their sales faster than their expenses, boosting profits and margins. In bad times, companies experience slowing revenues and cut costs to maintain margins. Better cost structures then allow companies to be more profitable once the economy turns around.

It may seem obvious that profits matter and that, over long time frames, they should reflect the value created by companies. Business owners, executives, and corporate boards have strong incentives to maintain and boost profitability and thus shareholder returns. When it comes to investing, there are three specific reasons why this matters to investors.

The stock market tends to follow corporate earnings

First, the stock market tends to follow corporate earnings in the long run. The accompanying chart shows that while the price and earnings of the S&P 500 do not line up perfectly, they follow the same broad trends. This is because economic growth boosts earnings which in turn pushes stock prices higher. So, while the economy and the stock market are not one and the same, the two are closely related through the performance of companies.

Second, whether the stock market is "cheap" or "expensive" depends not just on stock prices but also on corporate performance, the most important of which is arguably earnings. The price-to-earnings ratio, for instance, is simply the price of a stock or index divided by some earnings measure, such as expected earnings over the next twelve months.

What this means is that even if prices don't change, increasing earnings will make the market more attractive, and vice versa. The current S&P 500 price-to-earnings ratio is 18.7 times next-twelve-month earnings, above the historical average of 15.6 but still well below the 2020 peak of around 23. If earnings growth does begin to accelerate, this measure could improve further.

Dividends are an important consideration for all investors