The Only 3 Total Return Levers: Growth, Value, Dividends by Ben Reynolds, Sure Dividend
The formula for total return could not be more straightforward…
The total return formula is deceptively simple. It is a little too simple…
The most basic derivation of the total return formula hides the real vehicle of wealth creation under the title of ‘price change’.
Why Do Prices Change?
In the short-run, stock price fluctuations are virtually random. In the long-run, stock price changes are a result of two factors:
- Business growth
- Valuation multiple changes
As a business grows its earnings, it becomes more valuable. A company that makes $10 million a year is 10x as valuable as one that makes $1 million a year (all other things being equal).
When I say business growth, what really matters is profitability growth. If revenues grow while profits shrink, the value of your business has declined.
Unfortunately, even profits can lie. One year profits can be a poor judge of real earnings power (especially for cyclical companies). What matters is a company’s earnings power; the amount of money that can be consistently taken out of the company on an ‘average’ year.
Valuation Multiple Changes
The most widely used valuation metric is the price-to-earnings ratio. The S&P 500 has an average price-to-earnings multiple of around 15 over the course of its history.
Let’s assume that a company’s current earnings (as is often the case) are a good reflection of its real earnings power. If that’s the case, then the price-to-earnings multiple is a relevant valuation metric to use.
The price-to-earnings reflects the perceptions about a company’s future growth prospects. The higher the price-to-earnings multiple, the better a company’s perceived prospects.
In your personal life, you may have realized that when people have high expectations they are very difficult to please. Everything has to go perfectly. If not, the person gets let down.
The price-to-earnings multiple is the same way. When it is high, a business is priced for perfection. Unfortunately the world is a messy place. Things don’t always go according to plan. As a result, businesses priced for perfection will see their valuation multiple decrease when things don’t go according to plan.
As an example, if a company is expected to grow at 25% a year, and ‘only’ sees growth of 15%, its stock price will likely decline as it did not ‘live up to expectations’.
Buying stocks when the zeitgeist is against them is better. They are priced for weak results. Strong results will provide both real business growth (a plus), AND will likely result in an increase in the perceptions – and valuation multiple – of the stock (another plus).
A Better Total Return Formula
Instead of the overly simplified formula used in the beginning of this article, I propose a more instructive total return formula:
As an example, imagine a stock does the following:
Earnings-per-share rise from $10 to $11. The price-to-earnings multiple also rises from 15 to 18. No dividends are paid.
In this example, Earnings-per-share changed by 1.1 ($11 / $10 = 1.1), and the price-to-earnings multiple changed by 1.2 (18 / 16 = 1.2). 1.1 x 1.2 = 1.32. The stock price therefore increased by 32%. With no dividends, total returns for the investment were 32%.
If the company paid dividends as well, the total return would be higher by the amount of dividends paid divided by the initial share price.
Dividend Growth Investing and Total Returns
The total return formula shows where returns come from. A dividend growth strategy hits all 3 return levers. Click here for a dividend growth investing guide.
Dividend growth investors look for income. The lower the price of the stock, the higher the dividend yield (all things being equal). This leads dividend investors to (at least attempt) to invest in businesses trading at or below fair value – businesses with lower expectations.
Obviously dividend growth investors want dividends. Dividends are the most predictable of the 3 total return sources. Businesses with long dividend histories will very likely continue paying investors increased dividends.
Finally, dividend growth investors look for growing income streams. This means investing in businesses that are likely to see their earnings-per-share grow into the future.