Source of Return
I try not to obsess about share prices. Far too many people calculate an investment return by focusing on whether a share price has gone up or down over an arbitrary period. An investment return is not just a simple mathematical change in share prices. To understand why, you need to study the sources of return.
In 1991, John Bogle proposed a simple equation for the components of investment return. Some (read: very few) academics have also done some work on this and produced a similar yet rather complex equation. Bogle’s equation is as follows:
In layman English, it can be written as:
Dividend yield + earnings growth + repricing return
Dividend yield (the money the share pays you each year in dividends) (most important)
The underlying earnings growth of the company
Repricing return (the change in the PE ratio) (least important)
No complex mathematics is required to use the equation. I will use simple numbers to illustrate the concept.
The simplest part is the dividend yield.
I pay R100 for a share in Company A at the beginning of the year.
At the end of the year, Company A pays me an R5 dividend.
My dividend yield is 5%.
My investment return so far is thus:
Investment return = 5% + earnings growth + change in PE
Next, a company reports profits each year. This is also relatively easy to understand. For example:
Company A increases profits by 10% this year.
My earnings growth is 10%.
My investment return so far is:
Investment return = 5% + 10% + change in PE
The last component is the PE ratio. It matters the least. Unfortunately, many people fixated with PE ratios. The research I have read shows the return generated from PE ratio factor accounts for the least amount of total return. Some studies have even shown it to be close to zero percent in most markets. (See Rob Arnott’s article “Dividends and the Three Dwarfs” and John Bogle’s many books on the subject.)
For example, a company has a PE of 10. PE ratios tend to change in the short term depending on the mood in the market and are often seen as speculative in nature. Quite frankly, we have no way of knowing what a PE ratio will be in 1 year. If the PE increases to 10.3 and the company still earns the same, it means that the price must have increased. The change here is 3%.
After the discussion on PE ratios, we have completed Bogle’s equation:
Investment return = 5% + 10% + 3%
The total investment return is 18%.
Why should you care? The point is that you should worry about the two components of return over which you have some modicum of control. Investing is a business problem. Focus on companies with strong franchises and/or business models with strong inflation-beating earnings power and the ability to pay dividends. Construct a diversified portfolio of companies which pay healthy dividends every year. Forget about PE ratios. Forecasting whether a company is going to trade on a 10 or 11 PE at year-end is a mug’s game at best. PE rations are driven by sentiment. Sentiment is impossible to predict.
If you follow this conservative and disciplined investment approach, you are setting yourself up for a better-than-average investment return over the long term.