Annual Total Return Of A Stock
John Bogle, the founder of Vanguard and arguably the father of index fund investing used a simple formula to calculate estimated future annual total return, as described in his book, Don’t Count On It. Simply, the future annual total return of an asset is the income it generates plus the change in price. This is expressed as:
Future Annual Total Return = Income ± Change in Price
For stocks, income is represented by the dividend, or”
Future Annual Total Return = Dividend ± Change in Price
For stocks the ‘Change in Price’ can be further sub-divided into two components that are Earnings Growth and Annualized Change in price-to-earnings (P/E) ratio. This is expressed as:
Future Annual Total Return = Dividend Yield ± Earnings Growth ± Change in P/E Ratio
Let’s now briefly examine each component of the formula.
Dividends are the amount of cash distributions that companies pay out on periodic basis from earnings to shareholders. This amount is in excess of the capital expenditures needed for investing in and growing the business. The dollar amount of the dividend divided by the stock price gives the dividend yield. Hence, market action can affect the dividend yield and it can be a measure of valuation when compared to historical yields or market averages. Dividend yields can be a significant source of total return for companies in some industries, e.g. utilities, consumer staples, and financials. Note that distressed companies can often have high dividend yields due to large declines in the stock price.
Earnings growth is the amount that a company’s or stock’s earnings per share is expected to grow over time. In general, companies aim to grow their top line (revenue) and bottom line (earnings per share) over time. The value used here is the expected earnings growth. Past earnings growth is based on real data. On the other hand, expected earnings growth is an estimate. This is often difficult to determine. But it can be based on past EPS growth rates extrapolated forward, company’s guidance, or averages of analyst estimates. One difficulty is that earnings growth estimates may become unreliable for longer future periods of time due to the ups and downs of the business cycle and unpredictable company specific issues.
Change In P/E Ratio
Change in P/E ratio is simply the expected increase or decrease in the P/E ratio for a stock. The P/E ratio is the stock price divided by EPS. If the current EPS is used then the metric is P/E (TTM), where TTM = trailing twelve months. If the EPS is based on company guidance or analyst estimates, i.e. estimated EPS, then the metric is P/E (FWD), where FWD = forward. The P/E ratio will change with time as the company’s stock price fluctuates due to market action and EPS increases or decrease. The P/E ratio is commonly used as a metric for valuation.
The aforesaid Total Return formula works reasonably well but it is not perfect as seen in the chart below. The chart shows the sources of S&P 500 returns and the actual annual returns. By each decade, the aforementioned formula gives a pretty good estimate of the actual annual total return. But one caveat is that the earnings growth estimate needs to be based on sound assumptions. A second caveat is that the long-term valuation multiple needs to be reasonably accurate. If not, then the formula will result in too high or too low estimates of future annual total returns.