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Thoughts from Ralph Seger on this topic.

Evaluating Potential Future Total Return

Valuation deals with two ideas: Risk and Reward.

Section 3 of the SSG helps us explore the Risk side of valuation by calculating a Relative Value.

Section 4 of the SSG also helps us explore the Risk side of Valuation by calculating a price zone, and an Upside/Downside ratio.

Section 5 explores the Reward side of valuation by calculating two measures of estimated return: Total Return and Projected Average Return.

Click here for an SSG "Value" calculator where you can experiment with the numbers.

Components of Total Return

When using the SSG to evaluate the potential for future total return, it's useful to be aware of the three components that contribute to it:

• EPS Growth (over the long term, EPS growth is what drives a stock price higher);
• PE Expansion (if the PE  is higher when you sell than when you bought;  investors becoming more optimistic is what drives PE higher);
• Cash Dividends (a portion of earnings that the company pays to the shareholders in cash rather than being retained by the company to help fuel future growth).

There is an important difference between EPS growth and PE Expansion.  Earnings can continue to increase at a significant rate for a long time (decades), as long as the company can find a way to produce more revenue while keeping costs under control.  There isn't necessarily any set limit to how large earnings can grow.

The same isn't true for the PE of a stock.  PE can be reasonably expected to get higher only to a relatively limited degree.  Investors don't generally continue to get more and more and more optimistic without any limit in sight.  (That does sometimes happen, for only for relatively short periods of time.  When it does happen it's referred to as "irrational exuberance" or a "market bubble".)  Attempting to determine historical high and low levels of investor optimism (as measured by PE) is the main task in SSG section 3.  Estimating potential future high and low PE levels is one of the main tasks in SSG section 4.  The judgment you make for high and low PE in SSG section 4 places limits on what you think is reasonable to expect in terms of future investor optimism.

Dividends have been described as cash that a company pays to stockholders due to a lack of good ideas for how the company could effectively invest that cash itself.  If that's true, then why does NAIC teach that dividends should be reinvested?  Well, first of all, NAIC doesn't teach to always reinvest dividends in the same company.  NAIC teaches that you should reinvest dividends in order to take advantage of compounding.  Automatic dividend reinvestment plans are certainly convenient, but aren't necessarily the most profitable way to reinvest dividends.

For growth stocks, dividends are usually the smallest of the three components of total return.  PE expansion can be the largest component of total return over the short term (if you judge that it's reasonable to expect investors to be significantly more optimistic in a few years than they are now).  Over the very long term (decades), PE expansion contributes only moderately (if at all) to total return.  EPS growth generally contributes the most to total return over the very long term.

It's often pointed out that reinvestment of dividends has historically added significantly to market index returns.  However, the "dividends" part is what's usually emphasized, not the "reinvestment" part.  However, the fact that dividends were paid is not what added significantly to the market returns;  it's the fact that those dividends were reinvested so they could grow, compounded (driven mostly by future earnings growth), along with the rest of the investment.  And, those dividends were not reinvested back into the same companies that paid them but were reinvested in the market index (i.e., the dividends were spread out among all the companeis in the index).

Comparing total return with your future EPS growth rate (from SSG section 1) can be informative.  If your judgment in SSG section 4 anticipates the potential for significant PE expansion, total return will be significantly greater than your future EPS growth rate.  It's not reasonable to expect that "boost" from PE expansion to push total return higher than future EPS growth beyond the five years in your SSG study.  The reasonable expectation is if that high PE level is actually achieved during the next five years, any further price appreciation could not be at a rate higher than EPS growth (plus a bit from dividends), because it's not reasonable to expect PE to go any higher.

Evaluating Total Return

As a goal for return, BetterInvesting recommends using one that would double our money in 5 years.

With a simple return, this amounts to 20% per year (100% / 5 years = 20%). Say you invest a dollar and receive a 20% return on it for 5 years. At the end of each year you receive 20 cents which you remove and place in a jar. At the end of the five years you have the original dollar and the 5 payments of 20 cents each for another dollar. You've doubled your original investment.

However, since BetterInvesting recommends the reinvestment of all profits, it makes more sense to use a compounded rate of return. You still start by investing a dollar, but instead of putting the interest in a jar you invest it so you can earn interest on the interest. In this way, you'll only need about a 15% return each year to double your money in five years.  $1.00 x 1.15 x 1.15 x 1.15 x 1.15 x 1.15 = $2.01.

So people receiving a 15% per year gain (and reinvesting all the gains) should double their money in 5 years. If your goal is to double your money in 5 years, this does not mean every stock must earn 15% per year. It means your portfolio must average a return of 15% per year.

If you had two stock, each of which were worth $1,000.00, and one returned 10% per year and the other returned 20% per year, your average would be 15%. This is one of the reasons BetterInvesting recommends diversifying by size of company sales. Small companies are more risky, but can grow faster while larger compnies are more stable, but tend to grow more slowly.

ToolKit 5's new Portfolio's Reportcard feature will tremendously help you with this goal. Click here to download a demo copy of ToolKit 5 or click here to download its manual.

Total Return vs. Projected Average Return

Total Return (TR) is the measure of overall potential gain traditionally used on the SSG.  TR assumes a potential future price based on a future average high PE level.  Projected Average Return (PAR) is another measure of overall potential gain.  PAR assumes a potential future price based on a future average PE level.  Both TR and PAR assume the same future high EPS level.  The amount of PE expansion assumed to be achievable is greater with TR than with PAR.

• PAR is a plausible measure of anticipated rate of return for a stock if you are not practicing offensive portfolio management.
• Total Return is a plausible measure of anticipated rate of return for a stock if you are practicing offensive portfolio management.

If you don't know what offensive portfolio management is, you are probably not practicing it and may want to use PAR as an anticipated rate of return.

How do Changes to PE and EPS Affect Total Return?

What seems like a relatively small change in your judgment about future PE or EPS can produce a much larger change in the potential for total return.  For example, say you've got an SSG study showing potential total return over five years as 15% (in SSG section 5).  Then, you decide to be somewhat more optimistic about how high PE or EPS may become over the next five years.  What happens to total return if you decide to revise your judgment about future high PE and change it from, say, a PE of 20 to a PE of 25?  That 25% increase in high PE (in SSG section 4) would increase the potential high price by 25% but it would increase a 15% total return by 35% (to 20.25%).  A 25% increase in high EPS would do the same.

Say you decide to make a 25% increase in both high PE (say, from 20 to 25) and high EPS (say, from $2.00 to $2.50).  Doing that would increase the potential high price by 56% but it would increase a 15% total return by over 71% (to 25.7%).  A 36% increase to both high PE (say, from 20 to 27.2) and high EPS (say, from $2.00 to $2.72) would double a 15% total return (to just over 30%).

Why does this happen?  If reading about this in more mathematical terms interests you (remember your high school algebra?), click here.  Or, click here for an SSG "Value" calculator where you can experiment with the numbers.

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