The purpose of investing is to make a profit or, more specifically, to receive money in the future that is greater than the money that is invested today. In stock market investing profits come in the form of dividends (money received during share ownership) and capital gains (money received upon selling shares).
For example…I have $1,000. I invest my money by buying 100 shares at $10/share. I own the shares for four quarters and I am paid $0.10/share each quarter for total dividends of $40 (4 x $0.10/share = $0.40/share = $40 for 100 shares). I then sell my 100 shares for $11/share, which creates proceeds of $1,100 (100 x $11 = $1,100). My profit is $140 ($1,100 proceeds from sale – $1,000 invested = $100 capital gain; $40 dividend + $100 capital gain = $140 profit). The profit is $140 in four quarters, or 14% annual return on investment.
So, annual return on investment (ROI) is a function of:
- buy price – the price at which the shares are bought today
- dividend – the dividend paid while owning shares
- sell price – the price at which the shares are sold in the future
Can ROI be reliably predicted for a specific company, and used as a method for picking high performing stocks?
Forecasting Return
ROI is a function of buy price, dividend and sell price. As an investor I can control the buy price: I can decide what price I am willing to pay and I can decide not to buy at all if the price is unacceptable. I cannot control the dividend. Companies generally try to maintain a reliable dividend or even increase it over time but, if a company’s earnings decline, then they may be forced to decrease or even eliminate their dividend. The sell price is far less predictable than the dividend: the sale price is whatever other investors are willing to pay. I need a way to accurately predict the sell price. I will make four assumptions:
- Analysts estimates of future earnings are relatively accurate (this is a medium risk assumption – risk increases in frothy/bubbly markets with high PE Ratios)
- Dividends will be maintained throughout the ownership period (this is a low risk assumption for a company with stable earnings and a dividend that is not foolishly high – 8% or more)
- Any earnings not paid out as a dividend will add to the enterprise value of the company (this is a low risk assumption)
- The price at which the shares are sold in the future is directly related to enterprise value (this is a medium risk assumption – except for speculative stocks for which the risk is high)
If these assumptions are reasonably accurate then I can calculate the ROI for a given stock if i know:
- The price
- The analysts’ earnings estimates
- The current dividend
So, how does the math work?
Analysis Method
The process for estimating the ROI is as follows.
(1) Select Company for Analysis
For the purposes of illustration I will choose TransCanada Pipelines (ticker TRP.TO).
(2) Obtain Data
Price: The current price for a given stock is easily obtained from many websites. I use TD Waterhouse’s WebBroker website. The current price is $43.07/share.
Analysts’ Earnings Estimates: Consensus earnings estimates are also available from the TD Waterhouse WebBroker website. Earnings for 2011 are known: they were $2.23/share. Earnings for 2012 through 2015 are estimates. As the estimates move further out, fewer analysts contribute to the consensus (13 analysts are estimating for 2012 but only 2 for 2015). For reliability, I will include only the the first three years’ estimates in my analysis: $2.37 in 2012, $2.55 in 2013 and $2.74 in 2014.
Dividend: The current dividend is also available from the TD Waterhouse WebBroker website. It is currently $1.76/share.
(3) Analyze Cash-flows
As reliable analysts’ earnings estimates only exist for the next three years, the cash-flow analysis will use a range of three years. If I buy one share of TransCanada Pipelines it will cost $43.07 in this current year. A cost of $43.07 is shown as a negative cash-flow of -$43.07 in Year 1 (see table). The earnings during the first twelve months of ownership will be equal to the analysts estimate for 2012. (Note: This is only true if I buy the stock on 1st January. This is a simplification/assumption which should be conservative for a stock with growing EPS.) I will receive a dividend of $1.76 in the next twelve months, and every twelve month period after that. These payments are shown as positive cash-flows in Years 1, 2 and 3. If I sell after three years (at the beginning of Year 4). The price should be equal to the buy price plus the increase in enterprise value caused by retained earnings (earnings minus dividends). These retained earnings were $0.61, $0.79 and $0.98 in Years 1, 2 and 3 respectively, for a total of $2.38. The sell price should then be $45.45, which is shown as a positive cash-flow in Year 4. Adding the cash-flows from the buying the stock, the dividends and selling the stock gives us the total cash-flows for each year.
Year 1 | Year 2 | Year 3 | Year 4 | |
Buy | -$43.07 | |||
EPS | $2.37 | $2.55 | $2.74 | |
Dividend | $1.76 | $1.76 | $1.76 | |
EPS – Dividend | $0.61 | $0.79 | $0.98 | |
Sell | $45.45 | |||
Cash-flows | -$41.31 | $1.76 | $1.76 | $45.45 |
A spreadsheet can be used to calculate the Internal Rate of Return on these cash-flows. In this case of TransCanada Pipelines the IRR is 6.07%, which is not very high (I target 10% or more). The Price to Earnings Ration (PE) is 18.17, which is too high (I target 17 or less). The rate of growth is 7.52% which gives us a PE to Growth ratio of 2.42, which is also poor (I target 1 or less). TransCanada Pipelines is not a good value stock.
To obtain an IRR of 10% the price would need to be $26.50/share.