What Drives Your Stock Returns?

The only logical reason for someone to invest in any business is to make money. In this article, I am going to share with you how different factors could affect the share price of a company. Some of us may think it is just the earnings of the company, but the valuation of the company plays an important part too. Get ready to pick this valuation knowledge! This is one of the most important things that an investor needs to know!

What drives your returns?

(Figure 1: Earnings Driver. Full credits to Fred Liu of Hayden Capital)

While this may seem complicated, don’t worry. I will do everything in my power to make sure it is easy to understand. Let us set a default Price-to-Earnings ratio (PER) of 10x.

Scenario A – default

Let’s say you have a company that is earning Earnings Per Share (EPS) of $0.10. The market gives it a PER of 10x. What is the share price? It will be $0.10 multiply by 10, you will get $1.

Part 1: Effects of Multiple Expansion / Contraction on Share Price

Scenario B – multiple (valuation) expansion

The same company earns EPS of $0.10, the market gives it a PER of 15x. What is the share price? It will be $0.10 multiply by 15, you will get $1.50.

You will see, the extra returns of $0.50 ($1.50 – $1) come from the fact market values the company at PER of 15x instead of 10x.

This is what we call as “multiple expansion”. Remember, the EPS remains the same.

Scenario C – multiple (valuation) contraction

The same company earns EPS of $0.10, the market gives it a PER of 8x. What is the share price? It will be $0.10 multiply by 8, you will get $0.80.

You will see, the loss of $0.20 ($1 – $0.80) comes from the fact market values the company at PER of 8x instead of 10x.

This is what we call as “multiple contraction”. Again, the EPS remains the same.

Why does expansion or contraction happen? This could happen when the stock market favours one industry over another industry, or the company is switching from a high-growth stage to a low-growth stage. High growth companies tend to enjoy higher PERs.

Effects of Earnings Growth / Decline

Scenario D – earnings growth of 10%

The same company now earns $0.11 instead of $0.10 because the earnings grew by 10%.

• Valuing it at a PER of 10x, the share price would be $1.10 (10% gain)
• Valuing it at a PER of 15x, the share price would be $1.65. (65% gain)
• Valuing it at a PER of 8x, the share price would be $0.88. (12% loss)

Scenario E – earnings decline of 10%

The same company now earns $0.09 instead of $0.10 because the earnings decline by 10%.

• Valuing it at a PER of 10x, the share price would be $0.90 (10% loss)
• Valuing it at a PER of 15x, the share price would be $1.35. (35% gain)
• Valuing it at a PER of 8x, the share price would be $0.72. (28% loss)

So you can see that, despite earnings growth, the share price may come down if the stock market assigns a lower PER to the business (under scenario D, PER 8x)!

On the opposite side… the earnings dropped by 10% but because it has a PER of 15, the shareholder is still able to eke out a 35% gain (under scenario E, PER 15x).

Part 2: Dividend / Stock Buy Back

[Dividend]

Assume that the share price moved from $1 to $1.50, my returns would be 50%. However, the company also decided to pay me a dividend yield of 3%. My total return would be 53% (50% + 3%)

[Stock Buy-back]

Assume a company earns $10,000 and it has 10,000 shares outstanding. The EPS would be $1 ($10,000 / 10,000). I give it a PER of 10x, the share price would be $10.

Over the next year, it started to buy-back its own shares from the market. Altogether, it bought back 500 shares. The new outstanding shares would be 9,500 (10,000 – 500).

Assume that its net profit does not change, the new EPS would be $1.05 ($10,000 divided by 9,500). I give it a PER of 10x, the share price would be $10.50.

The extra gain of $0.50 (or 5%) is caused by the company purchasing its own share back.

Real Life Example

The best companies you would like to own are companies that will have [1] strong earnings driver, [2] multiple (valuation) expansion, [3] pay you a dividend, and [4] performing share buy-back. You have literally all the share price drivers to generate returns for you. The fact is, I haven’t found an excellent company like that.

But from my years of experience in the stock market, I bring you a relevant example of Monster Beverage.

On the extreme right corner, the share price increased 125x from 2001 to 2006. Was it purely caused by earnings alone? The answer is no!

1. The earnings grew 25x fold from 2001 to 2006.
2. Its PER grew 5x from 10x to 50x.

Multiply 25x (from earnings) and 5x (from multiple expansion), you will get a 125x increase in share price.

What Am I Searching?

I will look for quality companies with quality growth and not “dumb” growth. Why? No one control what valuation multiple that the stock market assigns to a company. The PER for any company could be 5x, 10x, 15x. But all I know is… I do not want the price contraction to work against me. 

I invested in a company that is trading at 10x PER and it is expected to grow by 30% in this upcoming year. At PER of 10x, I am looking for the share price to grow 30% as well.

If the share price remains the same, the PER will be “compressed” to 7.7x which I will think it is ridiculously cheap valuation. 

Actually, that is how your Price-to-Earnings-Growth ratio is formed.

Sometimes, my friends may scream at me, “Kelvin, why are you buying a company at a PE of 20?! Isn’t that high?” I will reply, “if I can safely estimate that the company is going to grow at 30%, I am purchasing it at a forward PE of 15.4x.”

Always consider the growth rate of the company against the PER you are paying for the company. The growth rate of any company is not something certain, you have to perform your own research to determine the probability and amount of growth that is conservatively achievable.

Let’s say I estimated 30% but it turned out to 10%, the PER is 18.18. That’s when the share price may start to fall as investors deem it as expensive.

Summary

• An investor MUST know what drives a stock price. It can be price multiple (PER), earnings growth, share buy-back, or dividends.
• The best engine for a share price to move up is… EARNINGS. Price multiple could change depending on how the stock market perceives the industry or company.
• Do your best to understand the equation of Price-to-Earnings ratio (PER) because you will then understand what drives the stock price.
• Your stock returns are determined by two things: growth and the valuation you pay. Price is what you pay, the value is what you get.

Now that you’ve understood PE ratio, try to explore and understand EV/EBIT which is a better valuation metric!

PS: I wish to express my heartfelt gratitude to my readers. Last night, I went to a BBQ session organised by my reader. I felt very welcomed and I experienced the group’s friendly atmosphere.

It was so great that we spent almost 3 hours sharing useful investing knowledge with each other. A thought flashed right across me, if I could build communities of strangers coming together and sharing knowledge genuinely, I am quite sure that investing could be easier for all of us. Hanging out with warm-hearted people really makes me happy!