How-To Calculate Expected Total Return For Any Stock by Ben Reynolds
The goal of rational investors is to maximize total return under a given set of constraints. Constraints include:
- Risk tolerance
- Current income needs
- Ethical concerns (no cigarette stocks, as an example)
This article shows exactly how to calculate expected total returns.
What Is Total Return?
Total return is the full return of an investment over a given time period. It includes all capital gains and any dividends or interest paid.
Total return differs from stock price growth because of dividends. The total return of a stock going from $10 to $20 is 100%.
The total return of a stock going from $10 to $20 and paying $1 in dividends is 110%.
It may seem simple at first glance, but total returns are one of the most important financial metrics around.
How-To Calculate Total Return
- Find the initial cost of the investment
- Find total amount of dividends or interest paid during investment period
- Find the closing sales price of the investment
- Add sum of dividends and/or interest to the closing price
- Divide this number by the initial investment cost and subtract 1
An example using the numbers from the dividend case in the ‘What Is Total Return’ section is below:
- $20 + $1 = $21
- $21 / $10 – 1 = 110%
How-To Estimate Future Total Return
Calculating total return after the fact is simple. There’s money to be made in accurately estimating expected future total returns in the stock market.
To understand how to do this for stocks, we have to break total return down into its components.
- Change in share price
Change in share price comes from 2 sources.
- Change in earnings-per-share (or less commonly book value, revenue, etc.)
- Change in price-to-earnings multiple (or other valuation multiple)
Therefore, the 3 aspects of total return for stocks are:
- Change in earnings-per-share
- Change in price-to-earnings multiple
The formula for expected total return is below.
The rest of this article shows how to estimate expected total returns with a real-world example.
We will estimate future returns for Coca-Cola (KO) over the next 5 years.
Coca-Cola is used as an example because it is a relatively simple, predictable business. This makes it a good choice for learning how to calculate expected total returns. With that said, this method can be applied to any stock investment. You can see the 10 highest total return Dividend Aristocrats here.
Note: The further out in time one estimates, the less reliable the estimate. Estimates of Coca-Cola’s return over 1 year will likely be more accurate than estimates over 10 or 20 years. The reason: more can change in 10 or 20 years than in 1 year.
Estimating Valuation Multiple Changes
Coca-Cola currently trades for $45.63 per share. The company has $1.97 in adjusted earnings over the last 4 quarters for a price-to-earnings ratio of 23.2.
From 2006 through 2015 Coca-Cola had an average price-to-earnings ratio of 18.6. The company’s price-to-earnings multiple traded for an 8% premium to the S&P 500’s price-to-earnings multiple over this time period.
The S&P 500 is very clearly overvalued from a historical perspective at current levels.
- Current S&P 500 price-to-earnings ratio of 25.0
- Historical average price-to-earnings ratio of 15.6
There are 2 questions surround Coca-Cola’s price-to-earnings ratio:
- Will it maintain its historical premium to the market in 5 years?
- Will the market still be overvalued in 5 years?
When one makes projections, one should always err on the side of conservatism.
Coca-Cola’s core soda business is experiencing headwinds in developed countries that are likely to persist indefinitely. On the other hand, the company is a market leader that still has growth potential internationally and with its still beverages. A price-to-earnings ratio in line with the S&P 500 is conservative, in my opinion, on balance.
The question of whether the market as a whole will be overvalued in 5 years is more difficult to answer. Low interest rates naturally lead to higher market values. Interest rates will very likely still be low 5 years from now.
Here are 3 different scenarios for the next 5 years:
- Market reverts to historical price-to-earnings ratio of 15.6
- Market maintains its current overvalued status at 25.0
- Market mediates to a price-to-earnings ratio of around 20
I believe that all 3 of these scenarios are about equally likely. The average of these scenarios is a price-to-earnings ratio of 20.2. We will use 20.2 as our expected price-to-earnings ratio for Coca-Cola 5 years in the future.
This is just guessing at the future however. Estimating a reliable price-to-earnings ratio into the future is very error-prone.
The image below shows the company’s change in expected price-to-earnings ratio over the next 5 years:
The above assumes a compound price-to-earnings multiple growth rate of -2.7% per year. We can expect that valuation multiple changes will be a drag on Coca-Cola’s performance.
The steps to calculate valuation multiple changes are below:
- Find current price-to-earnings ratio
- Estimate expected future price-to-earnings ratio
- Calculate compound annual growth rate of price-to-earnings ratio
We are one third of the way done with our calculations.
Estimating Expected Growth Rate Part 1: Underlying Business Growth
Growth should be estimated on a per share basis.
Why? Because share buybacks matter. A brief example is below:
Imagine a business generated $1,000,000 a year and has 4 owners. This business is valued at a 10x earnings multiple. The whole business is worth $10,000,000. Your share of the business is worth $2,500,000 with these 4 owners (lucky you!).
Now imagine that one of the owners wants to be ‘bought out’. The business uses cash on hand to buy out this owner. There are now only 3 owners left, and the business is still making $1,000,000 a year and has a 10x multiple. Your share of the business has now gone up to $3,333,333 because you own 33% of it instead of 25%. That is why share buybacks matter. If new shares were issued, the opposite effect would have occurred; your shares would be worth less. Investors should always estimate growth on a per share basis.
Growth comes from 2 places for public businesses:
- Share repurchases
- Underlying business growth
First, we will calculate the expected growth of the business.
The company is expecting adjusted earnings in 2016 to be around flat after accounting for expected negative currency fluctuations of 8 to 9 percentage points.
We will assume currency fluctuations will be flat over the remainder of Coca-Cola’s 5 year projections.
Coca-Cola has grown profit at 5.2% a year over the last decade. The company has a number of favorable growth prospects working for it, as well as negative soda trends working against it in the developed world. I expect the company to continue growing profit at around 5% a year going forward. This gives the company the following earnings expectations per year:
We can expect Coca-Cola’s underlying business to generate returns of 5% per year. This plus the company’s -2.7% per year price-to-earnings ratio compression means we are at expected total returns of 2.3% a year before dividends and share repurchases.
Second, we need to calculate the amount of share repurchases.
Estimating Expected Growth Rate Part 2: Share Repurchases