Contents
Ah the stock market
During the Soviet times, a granny addresses the president at a political rally: “Comrade Brezhnev, when will the times finally get better?” Brezhnev replies triumphantly: “Oh, the times already were better!” That pretty much gives the right answer to the question “when is the best time to buy stocks”: the best time is yesterday; the second best is now.
We live in eventful times: wars, both military and economic, are ripping the world apart; the economy is sputtering; AI is threatening to replace all workers; climate change is doing whatever, and Trump is blasting nonsense out of his social media accounts. We are not bored for sure. And yet the market keeps marching up, gradually but relentlessly, as if nothing but good times await. Many folks can’t reconcile that fact with what they see in the “real world”, and I keep getting bombarded with questions to help make sense of it all. “But Vlad, there were bad news yesterday, so why did the market go up?”. They feel almost offended that the stock market refuses to follow “logic”, at least as per their understanding of how markets should function. For that reason, I sat down to offer a mental model on how stocks work.
Along the way, the plan is to address (and debunk) many common misconceptions.
To make sense of what follows, it would help the reader to familiarize themselves with the previous chapter on inflation, or at least with its main conclusion: that the constant expansion of credit, predominantly government debt, is effected via an increase in the money supply, which in turn causes inflation of everything: the prices of assets, goods, and services. In other words, governments “print money” and that drives prices up. It would also help to bear in mind the relentless drift up of the stock market over many decades, as the chart of S&P 500 total return index since 1988 demonstrates — a respectable annualized return of 11.2%:
Breaking down the problem
Why do people buy stocks in the first place, and what gives a stock its value? We shall postulate that the value of a company derives from its potential to earn income (aka earnings) over time. There are of course other fringe reasons why people buy stocks, like bragging rights or because some influencer said so, and by God everyone who shorted GME knows better than to ignore those reasons! But what truly powers the market and gives value to a company and its stock is its ability to earn income.
With that in mind, let us break down a stock price (P) into earnings per share (EPS) and the quotient of P to EPS, otherwise known as the “P/E ratio”:
P = EPS x P/E
Now, let us be honest: EPS is a very crude way to measure the health of a company’s operations. First off, it is backward looking: things may look very different next year. And second, it may include one-offs like restructuring charges or divestment gains, which are not going to be repeated in future earnings seasons. CFOs get paid hearty sums of money to massage the reported earnings, and Wall Street analysts get paid equally well to decipher them. What we are presenting here is not an accurate valuation model that you can plug into your spreadsheet and go and trade out of; instead it is a simple framework for how to think of a value-generating asset in general terms.
Drivers of P/E
There is nothing miraculous about the above formula1: since the EPS is just a number we could look up from the company’s latest financial statement, the formula simply shifts the hard task of evaluating P to the more manageable task of evaluating the P/E, the latter being easier to approach because we can think of it in economic terms. For example, a P/E of 30 simply means that the market values the company at 30 times the annual income that the company last earned. As the price ticks up and down every second, and as the EPS remains the same (until the next financial year), it is essentially the P/E that is continually moving.
The P/E ratio is a forward-looking measure which essentially captures the market’s expectations of how fast the income will grow: a company with high P/E is expected to experience faster income growth than a similar company with a lower P/E. The P/E, unlike P alone, is a number we can compare across stocks.
Another way to look at P/E (or rather its inverse, EPS/P) is as a measure of return on capital or yield. If we are to invest $1 into a company with P/E of 20, that investment will be yielding 1/20 = 5% (or 5 cents in this case) as long as the company income remains the same. That is similar to a bond, or fixed deposit, which pays a coupon of 5%, except that with the bond we have certainty of both the coupon and the terminal value (the principal), whereas with the stock price we don’t.
This way of thinking of P/E is both helpful and dangerous at the same time. On one hand, it allows us to compare investments across assets, e.g. we can look at a stock with P/E of 20 (i.e. earning 5%), and a property investment yielding 5% of rental income. That is useful in terms of putting things in perspective, but it makes one very dangerous assumption: that the company earnings will remain the same. In fact, a high P/E signals precisely that the company earnings are expected to grow a lot in the future, and that expected growth is precisely what accounts for the high P/E. Consider a P/E of 40 (yield 2.5%), twice as high as the one in the earlier example. If we look at it from a yield perspective, we would assume that the stock is overpriced (and that the market is wrong) compared to the previous P/E of 20. But the market is rarely wrong. What the market is telling us is that this high P/E stock will likely experience high earnings growth.
But what is the “correct” P/E? Is P/E of 40 high when interest rates are say 5%? Well, it just says that $1 invested in the company will be earning 2.5 cents (if earnings remain the same) vs 5 cents in a fixed deposit. That sounds like a bad deal, considering that the stock yield is both lower and more uncertain. But that is precisely where the bodies are buried: the high P/E is telling us that the market expects the earnings not to remain the same; it expects the earnings to grow over time, no matter what reason: be it great company management or general inflation. So a stock with a P/E of 40 is not necessarily expensive.
To see how earnings growth impacts the P/E, assume a constant growth rate G. Furthermore, assume that all future cash flows are discounted using a constant interest rate I, which is composed of two things: a risk-free component R (dictated by central banks) and a risk premium component I-R, determined by the company’s business model. With a bit of math that we don’t care to elaborate here, and assuming that P is the net present value of the company’s future earnings, the formula looks like this:
P/E = (1+G) / (I-G)
Some useful conclusions can be derived from the above formula.
If G=0 (no income growth), the P/E is 1/I and the stock is basically a perpetual bond with a coupon I, i.e. at its worst, a stock becomes a bond. In other words, what makes a stock worthwhile in comparison to fixed income security is precisely the growth embedded in the earnings.
If interest rates go down, the stock price goes up. Notice that central banks (CB) tend to lower interest rates when the economy tanks in order to spur lending and reduce borrowing costs for the businesses, which immediately causes market prices to go up. In other words, negative news on the economy lead to CB action that instantly drives stock prices up. This is ironic, but it is a fact that often throws off newbies, who expect that good news on the economy should be good for the market.
Furthermore, notice that the denominator has I-G in it, so if G increases and approaches I, the P/E shoots up to infinity as the denominator converges to 0. In other words, P/E is extremely sensitive to G: small adjustments in the expected earnings growth can cause profound changes to the stock price.
Now, most importantly, remember that the company income could grow for any reason, as we are talking about nominal income in dollars and cents. This is a very key point that we will revert to later when we discuss the drivers of earnings.
Finally, lets take stock of one key fact about the two components to a stock price:
P/E is about expectations of how well the company will do in the future. It is a forward-looking metric and it impacts the stock price instantaneously.
EPS is about how the company did in its latest financial year. It is a backward-looking metric that impacts the stock price slowly.
Drivers of earnings
Companies employ people and capital to produce and sell their products and services. The more efficient a company is with its resources, the lower the cost and the higher the profit. The more effective a company is, the better the product and its sales and in turn the higher the profit. In other words, if a company is good at what it does, it earns high income, which means high EPS. High EPS justifies a higher stock price. This is how people often think of what drives EPS and we shall call this the “rosy perspective”: that smart management, motivated workforce, ingenious marketing, quality product, and happy customers lead to high and growing income and, in turn, to a high stock price.
But that view is too generous to a company’s management, because it ignores the simplest, yet most potent, driver of income increase: inflation.
Consider the following example. A bottle of Coke used to cost 5 cents in the early 1960s and it costs about $2 now. This is a price increase of 40 times, equivalent to an annual inflation of 6% (every year since 1962 for 63 years!). Imagine for a second that Coca Cola Co was selling the exact same number of bottles today as it did back in the 1960s and that it was maintaining the exact same profit margins, that nothing else differs in terms of management, workforce motivation, market share, product quality, customer satisfaction etc. The only difference is that both the top and bottom lines on the income statement are multiplied by 40. That means the EPS would have grown 40 times for no reason other than inflation, translating into a 40x increase of the stock price of Coca Cola Co.
As we learned in previous chapters, inflation is a monetary phenomenon driven by the increase of credit (primarily government debt) and has nothing to do with the management. And yet it has profound — and positive — impact on stock prices! So while it is often thought of as a “bad thing” that depletes consumers’ finances and makes them less prone to spend, it is actually great for stocks! Stocks love inflation! We will come back to this point when we look at the market level and draw some lessons from history.
Putting it all together
Back to the breakdown P = EPS x P/E. As we saw, inflation has a two-pronged impact on the stock price via each of the two components:
- Past inflation is what accounts for the growth of EPS. If we apply the same formula for the price of Coca Cola Co today and in 1960, we would see that the price has gone up 40 times solely because of inflation.
- Expectations of future inflation drive future EPS growth, and therefore impact P/E. Therefore even if we don’t experience any inflation yet, the mere expectation of inflation would pop the P/E and, in turn, the stock price.
Upon checking, the price of Coca Cola Co stock was 5 cents in the early 1960s and is about $70 now in 2025, a mouth-watering increase of 1400, far higher than the increase of the price of the drink. In other words, there is a further increase of 1400 / 40 = 35 times that is not due to inflation. But a big part of that is due to a higher P/E, since both interest rates and future inflation expectations are much higher today than they were in 1960. In other words, part of that 35x increase is again due to monetary phenomena (interest rates and future inflation expectations) and has nothing to do with the management prowess. But since 40 > 35, even without that monetary boost from the P/E, it would still be the case that past inflation (in the period 1960 ~ 2025) accounts for more than anything else combined in explaining the 1400x price increase of Coca Cola Co stock since 1960.
Aggregate market
Those who know me would often hear me advocate for investing in the entire market (e.g. via passive ETFs) rather than in individual stocks. So let’s look at the market as a whole. We could define
market EPS = sum(earnings)
market’s market cap = sum(market capitalization)
market P/E = (market’s market cap) / (market EPS)
where the sum is over all companies in the market index in question. Everything so far discussed about individual stock prices applies to the market as a whole. For example, the inverse of the market P/E can be interpreted as the “yield of stocks” and compared to interest rates. As of today, S&P 500 P/E is 28, i.e. a yield of 3.6%, lower than the 10-year treasury yield of 4.4%, which means the market expects moderate inflation ahead. We could also extend the same conclusions from individual stocks to the entire market:
- The main driver of the stock market is inflation.
- Interest rates are an additional driver of the stock market, and they are a lever in the toolbox of the CB.
- Bad economic news imply CB would lower rates, which is good for the market.
Since the stock market can react in the matter of seconds to any news, it is practically always forward-looking as any past information is already baked in the price. So while past inflation can explain past price increases, it is the changes in future inflation that drive changes in the stock market. Consider the “Big Beautiful Bill” that was recently passed in congress, which is projected to increase the budget deficit by $4 trillion dollars over the next decade. That will contribute massively to the future inflation of everything: goods, services, properties etc. However, the market doesn’t have to wait for 10 years for this inflation to get realized. The mere expectation of it drove the market to an all-time-high recently.
In fact, not just S&P 500 but all major stock indexes — Germany’s DAX, the UK’s FTSE, India’s Nifty are at or close to their all-time high (ATH). Gold and Bitcoin, two alternative investment assets, are also hovering near ATH. Properties all over the world are as expensive as they have ever been. Many people cannot reconcile all that with the “real economy” they observe all around. After all, we got the tariff wars, we got a new Cold War brewing, we got AI already causing mass layoffs of high paying employees, we have a demographic crisis in the rich societies. And we experience high inflation in healthcare, childcare, and housing that is choking us, particularly young families that are yet to get on the property ladder. And yet, the market keeps going up and up and up. Even in old boring Europe!
The answer is simple: it is all because of expectations of inflation. Markets love it when politicians print money. In fact, in times of heightened inflation, the stock market is the main beneficiary as it is the most responsive to news. It will take years before the new money seeps through the economy and causes the price of bread to go up. Property markets will rise faster than goods and services, but even there prices will rise gradually over time, as market participants’ expectations adjust slowly, and the transactions themselves take many months to close. But in the stock market, transactions and the dissemination of information take microseconds, so any time a politician opens their mouth to speak, the stock market is already reacting and adjusting its expectations for the next many years.
This nimbleness of the stock market is actually what makes it the best beneficiary of inflationary expectations. The best way to illustrate this phenomenon is to look at historical examples of extreme inflation caused by rampant monetary expansion. This article2 from 2007 about the hyperinflation in Zimbabwe is something I really wished I had read back then. If I had read — and understood its implication, I would be quite a bit wealthier today, because what it describes is not just an isolated example but a fundamental mechanism of the stock market, that was incidentally on display in the years 2009-2025 as CBs turned on the printing presses.
I know you won’t read it: many of my friends over the years failed to do so against my advice, and until today they keep coming back to me with the same dumb question: why is the market going up when it is already so expensive and the economy is turning sour? It is the inflation, dummy!
So what happened in 2007 is that Zimbabwe went through a hyperinflation, so bad that buying just a bread would require cartloads of currency bills — and much more in the evening than in the morning, since prices would jump up even during the day. Since Mugabe’s disastrous policies destroyed the economy, causing 80% unemployment, the only way for the government to fund itself was to print (and spend) even more money, adding to the inflation spiral. Essentially fighting fire with gasoline. But something miraculous happened: even though the value of the Zimbabwean currency was getting decimated and prices of daily necessities reached in the billions, the stock market was going up, clocking 12,000% return over a 12 month period. Not only did the stock market beat the inflation by a long shot, but it beat all other stock markets in the world in real terms, i.e. after adjusting for the loss of value of the currency!
Is it an ironic coincidence that the country with the worst economic decline would experience the best stock market returns? Is it a coincidence that the stock market was rising much faster than the inflation? No, there is no coincidence, and the article explains the mechanism that causes the stock market to be the first beneficiary of printed money.
To sum up, the main drivers of stock prices are interest rates and inflation, and both are entirely of a monetary nature and under the purview of the CB to manage. Stock prices have much much more to do with monetary policy — and expectations of future monetary policy — than with any economic “distractions” you would read about today, like international trade, geopolitics, unemployment, demographics, or whatever a crazy president last tweeted.
This isn’t to say that no other factors play a role. Innovation is surely a wind in the sails of the stock market. Technology is changing the way we live with e-commerce, video streaming, artificial intelligence, Ozempic, electric vehicles, self-driving cars, drones deliveries, and many more great inventions yet to come. That boosts the economy and shareholder’s wealth. But even in the absence of innovation, the market will keep drifting up because the main undercurrent remains the same: good old inflation.
It is worth admitting that not all stock markets are created equal. In a world where USD is the reserve currency, in which most international trade settles in USD, where the most liquid market is the US market, and where NYSE is the exchange where companies get their best listing valuation, it is only natural that liquidity anywhere in the world will ultimately flow back to the US market. For that matter, if you are wondering which stock market to invest in, my 2 cents are: just go for S&P 500 and forget about it.
Side notes
Why not go for dividends
Notice that throughout the text we referred to the company earnings and not the dividends which it may or may not be paying. The reason is that what gives value to a company stock is what it earns, irrespective of what it does with it afterwards. Whether it reinvests the earnings in its operations, or whether it returns a portion of it via share buybacks or via dividends is a subsequent decision.
Many people falsely believe the earnings are somehow “lost” if they are not immediately disbursed in cash as a dividend, and they often select stocks based on which one pays the higher dividend yield. This is a gross misconception that ought to be addressed.
Consider a common statement that sounds like this: “Well, your property may have appreciated in value, but unless you sell it there is no profit”. The underpinning assumption that “only cash in the pocket counts” is deeply entrenched in many of us. To illustrate why this is wrong, consider a piggy bank that holds $100. Your friends are laughing at you that you don’t really have anything since you can’t use a single dime of it (unless you break the piggy bank, which you don’t wish to do). But that is not true: the piggy bank is worth at least $100 even if the money is “locked inside it”. Would you sell it for $90 to someone who would quickly break it and pocket the $10 profit? Of course not. It doesn’t matter if the value is liquid or not, as long as you have the option to convert it to liquidity (break the piggy bank). It doesn’t matter if you break the piggy bank or not — what matters is that you have the option of doing so.
In fact it may be worth a lot more than $100, if for example it is the case that grandma puts $1 into it every week. In such case, you are better off keeping the piggy bank for as long as possible, even if that means deferring the moment when you get to enjoy its value. The value is real, even if it is locked in.
Back to the property example, if it has appreciated in value that is a valid profit, even if you haven’t sold it. In fact you may be crazy to sell while the property is still appreciating in value, even if the whole world is laughing at you that you don’t have a single dollar of profit since you are unable to encash3 it.
Back to the companies earnings. Whether a company retains the earnings or promises to return some of them in the form of dividends should make no difference to its value. After all, the question is similar to whether to keep the money in the piggy bank or to break it. Its value remains the same. Furthermore, in the case of stock shares:
- if a company doesn’t pay dividends, one could sell 5% of their shares to recreate “their own” 5% dividend; alternatively,
- if a company does pay dividends, one could reinvest the proceeds back into the company, creating their own “no-dividend” investment;
For that matter, the dividend payout has no direct impact on a company’s valuation.
Why dividends do matter after all
It is also true that the payout of dividends may indirectly signal something about the health of the company, which should be considered in its own context:
- Returning money to shareholders (via either buybacks and dividends) demonstrates discipline. I have personally witnessed egregious waste of funds in large corporations, driven by corruption, ego, self-interest, and outright stupidity. Lots of unnecessary hiring and overpriced acquisitions at inflated “goodwill” are bound to result in disaster down the road, so I have learned to appreciate it when a company returns excess capital to its shareholders.
- Changing a dividend payout is something companies avoid, as it may indicate (rightfully or not) a liquidity crunch, something especially long-time loyalist shareholders are very sensitive about. That is one reason many companies go out of their way to sustain a dividend payout regardless if it makes sense financially.
- Share buybacks may offer a more tax efficient way4 than dividend payouts to return money to shareholders. For some reason, though, it is seen in a negative political light by socialists who believe share buybacks should be outlawed in favor of forcing the company to pay higher wages. Silly as the argument may be, in those “eat the rich” times one must never be too complacent.
- Returning capital to shareholders may actually signal that the management sees no good prospects for deploying this capital to internal projects, and that may indicate that future earnings will stall. That is another consideration that should be taken in its own context.
In other words, dividends do matter, but not for the reasons that most people imagine.
A note on forecasting
Notice that none of the above statements imply that we have a tool to predict the market. Since the market is driven by people as they absorb new information, without knowing what information the future holds, we can’t conclude what the market will do. And that is by definition quite impossible (absent privileged information). By nature, any information that is widely available and known to the world is already baked in the price. Everyone’s expectations, knowledge, sentiments and fears are included in that one price.
“Is the market that efficient?” I often get asked. “How long does it take for newly released information to get reflected in the stock price?” is another common question. Well yes, the market is incredibly efficient and it takes virtually microseconds for the price to reflect the news, which for many years now has been processed not by humans but by machines that parse it and trade instantly on the market. So don’t hope you can outrun the market on something you just read. That piece of information is long buried in the market price under multiple layers of new information.
Conclusion
As promised, we go back to address some common popular (mis)beliefs mentioned throughout.
Q: “Market is crazy high now, so it is not a good time to buy”
A: Any time is good to buy. Just look at more than one century of stock market prices — it has gone up thousands of times, way beyond the price of gold and inflation. You can imagine that at any point in history someone was shouting “the market is too expensive now, don’t buy” only to watch it get even more “expensive”.
Q: “But the market is at P/E of 30 now, this is a historical high, there ought to be a correction!”
A: Maybe yes, maybe no. P/E of 30 is high by historical comparison, true enough, but all it says is that the market expects earnings growth that will be high by historical standard. Whether such growth is due to inflation or innovation like AI is secondary. What matters is that there will be growth, and we keep seeing it every quarter.
Q: “Can you guarantee me the market will go up from now?”
A: No I can’t, I don’t have a crystal ball. There are long periods of time when the market went side-wise. Remember that the market is forward-looking and the known information is already absorbed in it, so any expected “good news” is already in the price and won’t help the market grow from here onward. But if you are young and your investment horizon is long, you have got to invest in the market. History shows there is no better shelter from the ravages of inflation, and in fact, equities are the one asset class where the dreaded inflation actually works for you.
Q: “Profits only matter if they are in cash. Profit from a rise in the price of an asset is not a real profit.”
A: This misbelief is wrong on many levels. Not only is profit from price appreciation very real, but most of investment profits tend to come precisely from price appreciation rather than from distributed income: like dividends, in the case of stocks, or rent, in the case of property. But such thinking is surprisingly prevalent among otherwise learned people. That is one reason I wish they taught finance in school instead of, say, useless trigonometry.
Notes
- Such breakdown assumes the company already has some earnings. Pricing startups with no earnings and only expectations of earnings is an altogether different ballgame. ↩︎
- Mises Institute, Zimbabwe: Best Performing Stock Market in 2007 ↩︎
- In truth, one can access the property appreciation via equity loan, thus encashing the profit. But the argument is moot since your interlocutor is mostly predicated on envy and spite rather than genuine disagreement. ↩︎
- In certain tax jurisdictions, like in the US, dividends are double taxed unlike interest payments; in other jurisdictions, like in Singapore, dividends are only taxed at corporate level. ↩︎