Stock Returns – Earnings Growth, Price/Earnings Ratio, and Dividends

by Chris Perras, CFA, Chief Investment Officer.

There are three components of equity market returns over time.  They are 1) a company’s growth in earnings and free cash flow, 2) the change in valuation an investor pays for those earnings and free cash flow over time (P/E ratio), and 3) the dividend yield on a stock.  The first two factors determine an investors capital gains or losses, while dividend yield provides an investor with a stated, but not guaranteed, income stream.  We explore these three components of stock market returns in further depth for your education.

Earnings, Earnings Growth, and Free Cash Flow

Earnings per share (EPS) is the most important variable in determining a share price.  It is the portion of a company’s profit, after paying all costs including wages, rent, interest, and taxes, that are allocated to each share of common stock.  When an investor buys a stock, whether it is 100 shares or 1 million shares, this is ultimately what that investor is valuing.  It is not guaranteed!  It is variable and subject to the business and investment decisions of the management team running the company.

Price/Earnings (P/E) Ratio

The P/E ratio is the current price of the stock divided by a company’s current earnings per share.  Multiple factors drive a company’s absolute and future P/E ratio including the overall inflation rate of the economy, sector growth rate, and company’s individual growth rate.  In general, it is easiest to think of this rule when divining what you pay for your share of a company’s EPS:   Are things getting better or worse for the company I’m looking at investing in.

Specifically, the economic question we ask is “is the marginal return on invested capital (ROIC) for my investment accelerating, decelerating, or remaining constant”.  Changes in marginal “ROIC” can be brought about by many factors including new product releases, company restructurings, interest rate changes, or even lower tax rates.  When “ROIC” is stable to improving, investors most often are willing to pay a stable to expanding P/E multiple for a stock.  This “P/E expansion” helps leverage and compound investment returns above a company’s actual growth rate as optimism rules the day.

Alternatively, when the marginal “ROIC” for a company has peaked, it is almost impossible for a company’s P/E multiple to expand.  Most times, when a company is growing at high but decelerating rates, investors are best served investing in alternative areas or “indexing” these funds.  Think of this as trying to walk up an “down” escalator.  The gravitational pull of a declining P/E ratio outweighs the actual growth component of a company’s EPS.

Dividend Yield

Dividend yield is the third component of investment return and is just the dividend divided by company’s current market share price.  Dividends are not contractually guaranteed by a company!  There is no legal requirement that they be paid every year, however, most management teams do everything within their power to pay them once a trend has been established.

The percentage distribution of a company’s earnings, decided by a company’s board of directors, paid out to shareholders is its dividend.  This transfers economic value, usually cash, from the company directly to shareholders.  We like cash!  Cash is King!  Alternatively, some companies, usually in growth mode, use 100% of their profits internally for operations or corporate expansion.

When creating single stock portfolio allocations for clients, the OHFG investment team favors single stocks that pay dividends.  Our team takes into consideration the current stated dividend yield, a company’s ability to continue to pay its dividend, and the history of growing that dividend.  While cash dividends are a great investment tool, they are just one component of stock market total returns and investors should always remain cautious in stretching for dividend yield.

Views and opinions are subject to change without notice. Data cited is believed to be reliable but is not guaranteed. This article is distributed for informational purposes, and it is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, products, or services. Investing involves risk and past performance does not guarantee future return.