Wednesday, September 1, 2010

Investment Return & Speculative Return

The stock market has risen quite a bit in the last to days. I thought it may be apt to talk about the above.

Typically, investment return is the appreciation of a stock because of its dividend yield and subsequent earnings growth, whereas speculative return comes from the impact of changes in the P/E ratio.

Let's take a stock that trades for $30 per share, earns $1.50 per share and pays $1.00 in annual dividend. Assuming that earnings and dividends grow at 6% percent per year, and initial P/E ratio of 20 does not change.

After 5 years, earnings will be $2.01. So the stock should trade at $2.01 * 20 =
$40.20. Also, received in total $5.64 dividends. This work out to an annualized return of 8.8%, which is the investment return. Speculative return is zero because P/E did not change.

However, if earnings and dividends grow at the same rate, but P/E ratio decreases from $20 to $15. Then we will still have $2.01 in earnings after 5 years. The stock should trade at $2.01 * 15 = $30.15. Add in the $5.64 dividends which remain unchanged, the annualized return shrink to 3.6%. Conversely, a rise in P/E from 20 to 25 whould yield a fat annualized return of 13.3%

Conclusion, if you buy an excellent company which spits out consistently earnings and dividends like a clockwork but at a high price ie high P/E ratio, you will still suffer with a speculative decline when P/E ratio shrinks due to revaulation process. The dotcom bubble is a classic example when P/E steered into stratospheric regions without regard for fundamental valuation.

You should always pay for an asset less than your estimate of its value and not based on the hope that there will be someone willing to pay a higher price for it some time in the future.

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