Financial Reference

How much should you expect any one of your investments to return? If you’re investing in highly-rated bonds and expect to hold the bonds to maturity, the answer is easy: you should get the yield to maturity minus a small amount for the small probability of default.

However, what if you are trying to forecast the returns of stock? The analysis becomes much more complicated and is often misunderstood — even by experienced market commentators. Even, Michael Sivy, in the April 2006 issue of Money magazine (p. 78), gets the analysis wrong. He claims that since certain stocks are projected to have earning growth above 10% per year for 5 years and currently pay dividends above 1%, investors should expect average returns above 11%.

The problem with this analysis is that it assumes the future outlook of the company is the same as the current outlook. There is an embedded assumption in Sivy’s analysis that the P/E multiple is not going to contract (or expand). If the outlook becomes less favorable for these companies (i.e. the projected growth rate drops below 10%), the P/E ratio will probably contract and reduce the actual returns.

(On a side note, 10% growth is an optimistic assumption. The market as a whole can only grow as fast as GDP. GDP growth has averaged 3-4%, so 10% growth is 3 times the growth of the market as a whole. While 10% doesn’t seem like a crazily optimistic assumption, be careful of overly-optimistic growth projections — they can throw your whole analysis off.)

The shortcut used by Sivy to arrive at a projected ruturn is often used by laypeople to justify overpaying for growth stocks. The calculation that should be used is to value the company using a discounted cash flow analysis (whether it’s discounted dividends, free cash flow, etc.) to arrive at a current value for the company and it’s shares. You can then calculate a value for the company at any date in the future using the same assumptions you used in your initial calculation.

Many investors use multi-stage models (in which the growth assumption decreases over time) to reflect (1) that the near-future is more certain than the distant future and (2) eventually growth companies lose their growth potential and increase their earnings at the rate of GDP. If you assume a multi-stage model, the P/E will contract over time and your returns will be lower than simply adding the growth rate to the dividend rate.

Don’t fall for lazy solution Sivy falls for; go through the calculations (or at the very least reduce P/E expectations and return expectations) to arrive at a better forecast of your return.