Lesson 8 – What Determines The Rate of Return for Stocks?

 

rate of return for stocks
Photo by Adam Nowakowski on Unsplash

What to know what determines the rate of return for stocks, well consider this famous investment quote.

“In the Short-Run, the Market Is a Voting Machine, But in the Long-Run, the Market is a Weighing Machine”

This is a phrase originally attributed to Ben Graham but made famous by Warren Buffet.

It has a deep and profound meaning for those who actually understand it.

So what does it mean?

It simply means that in the short term, the stock market behaves like a popularity contest.

Stock prices change rapidly based on the environment, while the underlying value of the business doesn’t change.

People could chase fads and there could be various ways a stock might be manipulated in the short term.

In the short term, a stock could move for any number of reasons – news, global events, sentiment, forced selling, market psychology etc.

So it is a fool’s game for us small private investors to predict short term price movements.

However, over the long term, a 10-20 year period across multiple business cycles, stock prices tend to follow the performance of the underlying business.

The real value of the company gets reflected in the stock price. If a business does well, its share price will go up. If it does badly, it will go down.

So what determines this long term movement in share prices. Hopefully, that is what this lesson answers.

As always, I like to use real-world case studies to make a point.

For this lesson, we will use Nichols Plc, a beverage maker which owns many loved brands such as Vimto, Sunkist and Feel Good Drinks.

Shares of Nichols Plc have historically compounded at between 14% – 1^% per annum over the long term but there are interludes of wide variation in there (that’s the cost of equity ownership; it’s the nature of the asset).

So without further ado, these are the determiners of the rates of return on a stock over the long term.

Factor 1 – The Earnings Yield and Dividend Yield

The starting earnings yield and dividend yield are the foundation of return.

The earnings yield shows how much earnings per share a company generates from every dollar invested in the company’s stock.

It is the inverse of the price-to-earnings ratio or p/e ratio as it is more commonly known.

The dividend yield is the amount of cash flow you’re getting back for each dollar you invest in a stock.

It is calculated by dividing the dollar value of dividends paid per share in a particular year by the dollar value of one share of stock.

For, the year to 31 December 2019, Nichols plc showed earnings per share of 72.81 pence.

Looking at the current share price of approx £12 a share, the base earnings yield figure is 6.25%.

This is the amount that, if the company never grew and paid out 100% of its profits in cash, you’d collect regardless of what happened in the stock market.

So if you invested £1000 in Nichols plc, you would get back £62.5 every year.

Of course, a company doesn’t pay out all of its profits to its shareholders as it wants to grow and fund expansion.  

At the moment, 2.3% (£0.28) of the 6.25% (£0.7281) is distributed in the form of cash dividends, with the other 3.95% (£0.4481) ploughed back into the business or used for other capital purposes such share buybacks.

Factor 2 – The Growth In Diluted Earnings Per Share

Following so far? Great.  

If Nichols could just keep doing what it does, earn the same returns on capital, maintained the same dividend payout, and sat, ignored, for 25 years, we’d collect 6.25% on our initial investment at today’s price.  

That means to get to our 14% – 16% historical return, that other 7.75% – 9.75% has to come from somewhere.

The “somewhere” is the growth in the earnings per share, which is influenced by many different factors, including:

  • Nichols ability to sell more Vimto, Sunkist and Feel Good drinks,
  • Nichols ability to increase the price of its drinks at a rate equal to or greater than inflation,
  • Any new product launches or acquisitions that expand beyond the existing business,
  • The total population growth in Nichols markets as more people are born each year,
  • The rate of corporate taxation on earnings
  • Efficiency gains in manufacturing and distribution
  • Managements capital allocation decisions

Combined, these factors need to produce the other 7.75% – 9.75% in annual increase we need on top of the 6.25% base earnings yield to produce our 14% – 16% annual growth rate.

Factor 3 – Change In the Valuation Multiple Applied to Every £1.00 of Profits

The final determinant of our return is the multiple investors are willing to pay for every pound of profits.  

For example, if a company earned £1 and you paid £10 for it, you were valuing it at 10x earnings.  

Without growth, this would lead to a 10% return.  

This multiple is known as the price-to-earnings ratio and it depends upon two things:

  • The projected growth rate in future earnings (higher growth means a higher multiple because you can pay more and still do well)

 

  • The interest rate on long-term low-risk bonds (when bond yields are low due to low-interest rates, bonds become less attractive relative to stocks so investors are more willing to buy stocks as they can get higher yelled from stocks than bonds. When everyone is competing to buy stocks, the share price increases thus stocks have higher multiples.  The opposite is also true.)

To go back to our Nichols example, over the past year, Nichols earned £0.7281 a share in profits.

The company is currently trading at about £12 a share.

This means for every £1.00 in after-tax corporate profit, investors are willing to pay £16, or a £16 multiple. (12/0.7281 = 16)

Why does this matter?  

Let’s imagine for a moment that Nichols grows its earnings at 5% for the next 20 years (there is no guarantee it will, I’m just pulling a number out of a hat to illustrate the concept we are discussing).  

Further, let’s assume it holds it dividend payout ratio steady so dividends increase in direct proportion to profits.  

A quick back-of-the-envelope calculation tells us that over the next 20 years, each share of Nichols would deliver £24.07 in net income.  

Of this, £9.25 was paid out in cash dividends and £14.82 was retained by management.  

In the final year, diluted earnings per share would be £1.83

What is the stock price?  

It depends on the multiple applied to that £1.83.

 If the same 16x rate applied that is in effect today, the stock would trade at £29.28, plus you’d have your £14.82 in cash dividends, meaning you turned an initial investment of £12 per share into £44.  

That’s a compound annual growth rate of 6.8%.

Now Imagine interest rates skyrocket, Nichols prospects dimmed due to higher sugar taxes and the like, and investors were only willing to pay a multiple of 10x profits.

 In this case, the share price in 20 years would be $£8.3 in the final year, plus you’d have collected £14.82 in cash dividends for a total of £33.12 or a compound annual growth rate equal to 5.2%.

Isn’t this amazing.  The exact same profit growth. The exact same dividend growth.  

But in one scenario you ended up with 6.8% compounded and in another 5.2 %.  

Your final wealth would be significantly different;£44 versus £33

But keep in mind one important thing: The valuation multiple in the final year only matters if you plan on selling in that final year.  

In both scenarios, you still received cash dividends of £14.82 to date.  In both scenarios, your annual dividend income in the final year is £0.70.  

If you don’t need the money from the stock itself, you can live off those cash dividends and continue to hold the stock.  There will have been no practical effect on your day-to-day life, either for good or bad, in either situation.  

In both scenarios, you could have juiced your return a percentage point or two by ploughing the dividend back into more shares, reinvesting it so the dividends were generating dividends of their own.

We have not considered dividend reinvestment in this example in order to keep it simple but it is a possibility. (Have a look at my example on GSK to see what I mean).

So there you have it. The three factors that determine the rate of return for stocks.

Namely,  the initial base earnings yield / the dividend yield you collect, the subsequent growth in the earnings and dividends thereafter and the ending valuation multiple applied to final-year net income.

Sure there are other considerations such as dividend reinvestment and taxes but we have aimed to keep it simple.

Hopefully, this lesson has been useful to you and be sure to check back as I will be posting new lessons periodically. 

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