I’ve been contemplating quite a bit recently with regards to the concept of total returns versus the usual intrinsic value calculation, which is the modern day norm. Too often we are inundated with all the data and noises that we forget that there is a simple logical formula for the total return of an investment in a stock.
If we think about it, the return from an investment in common stock of a company is made up of the following:
1. Dividend Yield
2. Earnings Growth/Contraction
3. Multiple Expansion/Contraction
4. The reinforcing or balancing interaction between earnings and multiples
Therefore, in simple terms, the mathematical total return can be expressed as the formula below:
Total Return = Dividend Yield + % Change in EPS + % Change in P/E + (% Change in P/E * % Change in EPS)
Let’s walk through a few scenarios.
Scenario 1:
| Â | Present | 1 Year Later | % Change |
| EPS | 5 | 6 | 20% |
| Dividend | 1 | 1 | 0% |
| P/E | 20 | 25 | 25% |
| Implied Stock Price | 100 | 150 | 51% (50% price return + 1% dividend yield) |
Plug in the numbers to the formula:
51% = 1% + 20% + 25% + (25%*20%)
Scenario 2:
| Â | Present | 1 Year Later | % Change |
| EPS | 5 | 6 | 20% |
| Dividend | 1 | 1 | 0% |
| P/E | 40 | 30 | -25% |
| Implied Stock Price | 200 | 180 | -9.5% (-10% price return + 0.5 % dividend yield) |
Plug in the numbers to the formula:
-9.5% = 0.5% + 20% - 25% + (20% x -25%)
Scenario 3:
| Â | Present | 1 Year Later | % Change |
| EPS | 5 | 4 | -20% |
| Dividend | 1 | 1 | 0% |
| P/E | 20 | 18 | -10% |
| Implied Stock Price | 100 | 72 | -27% (-28% price return + 1% dividend yield) |
Plug in the numbers to the formula:
-27% = 1% - 20% - 10% + (-20%*-10%)
Scenario 4:
| Â | Present | 1 Year Later | % Change |
| EPS | 5 | 4 | -20% |
| Dividend | 1 | 1 | 0% |
| P/E | 4 | 6 | 50% |
| Implied Stock Price | 20 | 24 | 25 % (20% price return + 5% dividend yield) |
Plug in the numbers to the formula:
25% = 5% - 20% + 50% + (-20%*50%)
All above four scenarios are in the most simplistic form for illustration purposes. Readers may have noticed that the first two scenarios resemble growth companies and while the latter two remind us of declining businesses. I purposely left out the scenarios where earnings are flat. I encourage the readers to try this exercise on their own.
What is clear from the above scenarios is that while the percentage changes are the same, the total return in our imaginary scenarios differ vastly. The question is why is that?
From my observation, most of the time, investors focus only on the first two parts of the equation. Namely, dividend yield and earnings growth. This is understandable because they are at the core of fundamental analysis. What is missing, obviously, is the anticipated change in multiple and the reinforcing or balancing interaction between earnings change and multiple changes. Said differently, the psychological part of investment analysis, or arguably what Howard Marks (Trades, Portfolio) calls the human side of investing.
In scenario 1 and scenario 2, the business grows its earnings by 20%. However, the expectations are so high in scenario 2 that an investor could actually lose almost 10% in a company growing earnings at a fabulous rate. If you think this is just all hypothetical, take a look at Wal-mart and Coca-Cola’s history; you will find repeated patterns of both scenario 1 and 2.
Similarly, in scenario 3 and scenario 4, the business shrinks its earnings by 20%. However, the expectations are so low in scenario 4 that an investor could actually make 25%. Recent examples include Dell (DELL, Financial) and Hewlett-Packard (HPQ, Financial). The expectations were so low and both businesses were still profitable. When a stock is selling at a P/E multiple of 8, a change from 8 to 9 is 12.5%, from 8 to 10 is 25% and from 8 to 12 is 50%. A 50% multiple expansion from low levels can perfectly offset the decline in earnings, as we can tell from the total return formula.
The lesson is clear: While earnings and dividends are enormously important, it would be foolish to ignore multiple expansion/contraction and the reinforcing or balancing interaction between earnings and multiples.
Before I end this article, let me point out that this total return formula is just a broad framework. It won’t apply to special situations and it won’t apply to cigar butts. When you apply it in reality, you won’t be able to figure out what will happen to either earnings or to the multiples. Faced with this dilemma, we have no choice but to resort to the core of value investing - margin of safety.
