What Really Drives Stock Market Returns?

When it comes to income investing, it’s pretty easy to get focused on just a couple of key themes. If you’re like many else out there, the first place you might start is with the dividend yield. The dividend yield represents the return you’d expect to make on a stock using past dividends at the current share price.

For example, if a share is trading at $5 and the company has paid out 20 cents in dividends over the last 12 months, then the dividend yield is 4%. (20 cents divided by $5 multiplied by 100). While the dividend yield might be one place to start, it really only tells one part of the story.

Another popular measure to look at is the payout ratio. This is the amount, usually expressed as a percentage that the company pays out to its shareholders from its net income. As you’d expect, a company with a 70% payout ratio pays out 70% of its net income to its shareholders in dividends.

To calculate the payout ratio, you divide the dividends per share (DPS) by the earnings per share (EPS). A company earning 60 cents per share and paying out 30 cents per share in dividends has a payout ratio of 50%.

The payout ratio gets quite a bit of attention from investors and analysts, as they want to know whether the dividends paid out by the company are sustainable. Any company that disappoints its investors by lowering or cutting dividends is usually punished by the market.

Obviously, this is something that the company’s board want to avoid. Rather than reduce dividends, they might choose to increase the payout ratio instead. However, if the company’s profits aren’t growing, then it’s only a matter of time before this too becomes unsustainable.

It’s easy to get caught in yields and payout ratios and looking at earnings growth and company profits without looking at how a business is really travelling. After all, if a business is growing and profits are increasing, then surely that’s a good thing for its investors.

But there are a number of limitations to looking at stocks this way. For a start, a company with growing profits and earnings growth could be financing this through ever increasing levels of debt. A company might use some of the borrowed funds to finance a dividend — surely not the best use of its capital.

Or, the increased growth could be purely driven by acquisitions. While profits might steadily increase, so too are the company’s debt levels. In a low interest rate environment, they might get away with this for a while only to get caught out if rates eventually rise.

That’s why there’s another important measure that analysts and investors use — particularly value investors — to try and gauge how a company is really performing. It’s called the return on equity (RoE). It gauges how much a business is actually making from the funds invested from shareholders.

Think about it from this angle. Imagine someone is retrenched and after looking around decides to buy a mowing round. For $20,000 they get the rights to a handful of suburbs, plus signage and all the equipment they’ll need to carry out their job — a line trimmer, mower, trailer and all.

The first 12 months go particularly well. They’re earning good profits, have an ever growing customer base, and can hardly keep up with the work. After sitting down with their accountant, the business posts a $10,000 profit — a 50% return on their investment.

The head franchisor then gets in touch to tell them that a mowing round from a surrounding area has just come up for sale. After thinking it over, they pay the $20,000 asking price and soon get to work.

However, they’ve got to employ someone else and travel a lot more to do all the work. Plus, some of the customers prove to be bad payers and complain about some of the work. What seemed like a good business idea has now become not much more than a headache.

After sitting down with the accountant to do the next year’s books, the new mowing round only returned a $2,000 profit. For all the work and drama, it was hardly worth the exercise. Yes, the business is growing and profitability has increased. They are certainly making more ‘profit’. But their borrowings have increased along with a lower return on their capital.

While the return on the new round is 10%, it has lowered the return on both business to 30%. The business owner has now used $40,000 of capital and is wondering whether they should offload the second business and put the money in the bank.

It’s the same with companies on the stock market. A company can keep borrowing to buy more businesses or invest in organic growth of its own from retained earnings (the funds left over after distributions). But the real measure is how much return they make from the funds invested.

After all, if a company is only returning three or four percent on its equity, wouldn’t it be much safer to just park the funds in cash until a better investment is found? Ultimately, it’s what a company earns on the funds invested that decides the value the market will put on it. That’s why you see the big institutional investors attacking companies that deploy their capital poorly.

Return on equity is one of the most popularly used ratios by long term, value investors. Much more useful to them than just the current yield or profit growth numbers. It tells them the true value of a business as it shows exactly how much a business is making. While businesses might fool the market for a while, in the end the market always establishes what it’s worth.


Matt Hibbard

From the Port Phillip Publishing Library

Special Report: You probably already sense that stocks might be in for another bumpy ride in 2016. But that doesn’t have to mean that you have to miss out on making great money. Because, according to small-cap analyst Sam Volkering, certain stocks could rise hundreds of percent no matter what happens in the next 12 months. In this special report, Sam reveals the simple principle behind that success. And you’ll also discover his top three small-cap picks for 2016, which could bring you gains as high as 338% over the next 12 months. (more)

Join Money Morning on Google+

Money Morning Australia