Thursday, 28 July 2016

What determines the returns from stocks?

Very long-run returns from common stocks are driven by two critical factors:

1.  the dividend yield at the time of purchase, and,
2.  the future growth rate of earnings and dividends.

In principle, for the buyer who holds his or her stocks forever, a share of common stock is worth the "present" or "discounted" value of its stream of future dividends.

A stock buyer purchases an ownership interest in a business and hopes to receive a growing stream of dividends.

Even is a company pays very small dividends today and retains most (or even all) of its earnings to reinvest in the business, the investor implicitly assumes that such reinvestment will lead to:

1.  a more rapidly growing stream of dividends in the future or
2.  alternatively to greater earnings that can be used by the company to buy back its stock.

The discounted value of this stream of dividends (or funds returned to shareholders through stock buybacks) can be shown to produce a very simple formula for the long-run total return for either an individual stock or the market as a whole:


From 1926 until 2010:

Common stocks provided an average annual rate of return of about 9.8%.
DY for the market as a whole on Jan 1, 1926 was 5%.
The long-run rate of growth of earnings and dividends was also about 5%.
DY + Growth rate gives a close approximation of the actual rate of return.

Over shorter periods

Over shorter periods, such as a year or even several years, a third factor is critical in determining returns.
This factor is the change in valuation relationships, namely, the change in the price-dividend or price-earnings multiple.
[P/Div and P/E tend to move (increase or decrease) in the same direction.]

Ref: A Random Walk Down Wall Street

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