The Wealth of Nations Chapter 9: Of the Profits of Stock

In an earlier chapter we learned that there are three components of the price of something:

1. Wages

2. Profit

3. Rent

In our final chapter with Smith, he explores profit. Profit, by definition, is what’s left over after all other expenses are covered. If you are in the business of corn, after you pay for the land, pay for the labor, pay for all other expenses related to growing the corn (seed, fertilizer, tractors, storage, etc.), the money that’s left over that does not need to go toward any costs is called profit. Profit is the financial motivator of business. If there is no opportunity for profit, individuals would have to take on personal financial risk for no reward – something that would not be possible except for the wealthiest of individuals (likely because of a high profit from another endeavor).

Smith acknowledged that knowing what various businesses earned at profits varied so much even moment by moment there was virtually no way to know what a business’ profit was. We have a better insight given the reporting requirements from publicly traded companies and industry specific studies, but Smith was nearly in the dark. That said, he found that he could use interest rates as a proxy. If a business was regularly willing to pay 5% to borrow money, it was because their profits were at least more than this 5%, and often closer to double what they had to pay in interest. “It may be laid down as a maxim, that wherever a great deal can be made by the use of money, a great deal will commonly be given for the use of it; and that, wherever little can be made by it, less will commonly be given for it.”

Long term financial success for nearly every American requires participating in (i.e. getting a piece of) the profit of other businesses. Profits are the rights of owners, so the only way to receive these profits without starting your own business is to buy part of someone else’s. This is what happens when you invest in stocks, you buy a small piece of a large company and are entitled to the profits. “Money, says the proverb, makes money. When you have got a little, it is often easy to get more. The great difficulty is to get that little.”

So the question is, which companies will have the highest (sustainable) profit? Like you, there are a few other people who want to own (and only own those). Because of this (supply and demand), the stock price goes up. The top companies in the US public markets have been selling for about 28x their earnings. In order words, if you can expect $1 of profit, you’ll have to pay $28 to get it. 28 years to breakeven doesn’t sound great, which is why betting on those companies is betting not on their current earnings, or often even their future earnings, but instead some other investor to come along and pay you more than $28 for it.

Other companies, ones that are not as shiny and don’t get as much media attention, have been regularly turning a profit decade after decade, and then giving a portion of that profit to the owners in the form of a dividend. These “value” stocks might not have the potential to boom like some tech companies have, but they also don’t have the same bust risk as those same stocks do either.

Unfortunately, Smith also lets us know that market interest rates are helpful in evaluating what profits we can expect only in a free market, not one where governmental bodies attempt to influence the interest rate, as we have today. Interest rates in the US were nearly 0 since the Great Financial Crisis, increased during COVID, and we’re waiting to see how things shake out.

Our investment approach is to diversify, because we have enough humility to know that we don’t know which companies are going to actually be worth their 28x price, and which are all hype. Your retirement income should not hinge on the decisions of Federal Reserve Chairs or CEOs, but instead on what we can control. You and I may not be able to influence the wealth of nations, but we can with our own wealth. I’m grateful for Smith’s work here and the economists who have carried on his work, giving us an insight into the productive activities that generate wealth and improve quality of life.

Let us know

• What’s the highest interest rate you’ve paid to borrow money?

• How much would you pay for each dollar of annual income?

Until next time, happy reading!