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How To Calculate Investment Return

November 25th, 2011 Leave a comment Go to comments

You’ve identified a great investment which you think is valued attractively (e.g., that great company is selling at a P/E which is near its earnings growth rate).

How much money will you make? Before you buy, you should have a good idea and an equal amount of confidence of how you will make money and how much you will make. If you don’t do this, the market will surely test your confidence in that investment through volatility, bear markets and reactions to company news.

Any kind of return model will necessarily have to model your capital gains (increase in the price of your investment). If you are a value investor, whereby you are buying investments that pay you dividends, your job is much easier. The return model I will talk about ignores capital gains as an input.

So, we don’t ask the question, “If I buy now, how much higher will the stock go?”. That’s the wrong question. You want to know how much the earnings will increase and then, the stock price should follow. No one can predict what the market will do concerning prices, but you can make a good estimate on future earnings when you use facts. This is also a type of predicting the future but predicting the future on facts is easier than predicting it on the gyrations of the stock market which often gets distracted from company fundamentals.

So, on to the model.

Dividend Growth Investment Return Model

The return model had been around for a long time though I first learned about it from Morningstar. They offer a lot of great information for investors I do recommend them.

Here’s how to calculate investment return:

Average Annual Return = dividend yield + dividend growth rate

There’s a lot implied in this formula. A good company will translate earnings increases in dividend increases. When you look for investments, one of those traits you are looking for are companies that translate earnings growth into dividend growth (any divergence could be a red flag or at least require further follow up). Wall Street typically focuses on earnings and ignores dividend growth (though dividends do seem to be in fashion now?).

If you focus on these type of investments you will be more successful because companies that focus on shareholder return will work to make you money. Then, the market will have no choice but to value those investments higher.

Also, a growing dividend implies that the dividend itself is adequately funded and supported by the business. This is a starting point for a good investment, a sustainable current dividend.

How To Estimate Dividend Growth

The dividend growth rate is usually a long term growth rate, 5 years or more. If you use stock analyst reports, they may offer an estimate of the earnings growth rate. It’s harder to predict when you consider the long term, so it’s better to be conservative and to assess whether the company has the moat and business acumen to succeed over longer periods. (The past can offer some help here).

There are some analysts who will quote a dividend growth rate (Morningstar comes to mind), but if that is not available then earnings growth rates can substitute. Examine the track record of the company to be sure that earnings growth translates into dividend growth.

What Should You Expect?

Wall Street often quotes stocks as returning 9-11% over the long term. This is a diversified market portfolio or index. If you are investing in individual stocks, keep it conservative but shot for the fences. This means buy stocks that you think will return 12% or more but keep your expectations in check. There’s nothing better than being pleasantlysurprised when an investment outperforms realistic, but conservative expectations.

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