Valuation matters. The less you pay for a shares of a great business, the better.
“Long ago, Ben Graham taught me that ‘Price is what you pay; value is what you get.’ Whether we’re talking about socks or stocks, I like buying quality merchandise when it is marked down.”
– Warren Buffett
Growth also matters. The faster your investments grow earnings-per-share and dividends-per-share, the better.
Growth and value are important parts of a successful investment…
But dividends also matter. A fast growing business trading at a discount is great. A fast growing business trading at a discount with a high dividend yield is even better.
The problem is that:
- Growth investors focus primarily on growth
- Value investors focus primarily on value
- Dividend investors focus primarily on dividends
What if you could combine value, growth, and dividends?
What if there was a formula that captured the interplay between these 3 investing factors?
Fortunately, there is. Total Return is what really matters.
This article examines the total return formula. It also includes the current Top 10 Dividend Aristocrats based on expected total return so you can put total return to work for you.
The Dividend Aristocrats are a group of 50 S&P 500 stocks that have paid increasing dividends for 25+ consecutive years. Click here to see all 50.
The Total Return Formula
The formula for total return over a period of time is:
This in itself is not particularly valuable. It is backwards looking.
The total return formula becomes more interesting when you examine why the share price changed.
Earnings tend to drive stock price valuation. The change in share price is also the change in earnings-per-share multiplied by the change in the stock’s price-to-earnings ratio.
The 3 levers that affect total return are:
- Valuation multiple changes (value matters)
- Earnings-per-share changes (growth matters)
- Dividends paid (dividends matter)
Interestingly, this aligns with the 3 broad ‘types’ of investors.
Instead of looking backwards, we can use these levers to estimate future total returns – which is very useful for comparing different investments to one another.
The above formula is useful in theory. The section below shows how to put this knowledge to use in practice.
Total Return Example
To use the total return formula to compare investments, you must have growth and valuation multiple estimates.
Estimating the ‘fair value’ multiple for a business is an art, not a science. Investors coming up with an estimate should consider:
- The company’s historical average price-to-earnings ratio
- The market’s current price-to-earnings ratio relative to average
- The company’s peer’s price-to-earnings ratios
Let’s imagine after doing research, you find a stock you believe should have a price-to-earnings ratio of 20. The stock is currently trading for a price-to-earnings ratio of 16.
Next you need to estimate expected future growth. Again, growth estimates are an art not a science. The following should be considered:
- Historical average dividend growth rate
- Historical average earnings-per-share growth rate
- Analyst expected future growth rate
Unless there is a very good reason, your expected growth rate should be somewhere in line with the above.
For our example, let’s pretend you estimate growth (on a per-share basis) at 6% a year.
Dividends are the most straightforward. Use the company’s current dividend yield. For our example, we will assume the stock has a 3% dividend yield.
To summarize, our estimates are below:
- P/E Ratio change of 25% (20 divided by 16)
- Growth rate of 6%
- Dividend yield of 3%
You still can’t calculate expected total return. The time it takes the company to reach fair value factors into the calculation as well.
Based on my analysis, the overall market mean reverts on average over a 6 year period. Benjamin Graham typically held his value stocks for 2 years. If they didn’t hit fair value in 2 years (or even if they did) they were sold.
If there is a catalyst in place, reaching fair value could happen very quickly. If not, it could take a very long time (if ever – you could have calculated your fair value multiple incorrectly).
I believe 6 years is a very conservative estimate of reaching fair value. It’s better to be conservative and err on the side of caution. We will use 6 years for our example.
Our 25% P/E ratio change over 6 years needs to be annualized. To annualize returns, do the following:
(1 + P/E Ratio Change) ^ (1/# Years) -1
Using our example, this comes to 3.8% on an annual basis. Plugging the numbers into our formula, we get:
+ 3% Dividend Yield
+ 6% Growth Rate
+ 3.8% P/E Ratio Change
= 12.8% Expected Total Returns
Using our expectations above, we get an expected total return of 12.8%.
There is a lot that can go wrong with total return investing…
Level of Certainty in Estimations
There are no perfect solutions in investing.
Total return captures the essence of what drives returns in the stock market.
The problem is with us non-time-traveling humans… Our estimates are always wrong.
This adds in another complication – level of certainty. Growth and value estimates for a stock like Coca-Cola (KO) are likely going to be more accurate than estimates for a 3 year old biotech firm.
Investors looking to come up with more accurate total return estimates should come up with multiple scenarios and the estimated probabilities of those scenarios occurring. This rewards more predictable stocks for their predictability – and (fairly) tempers expectations of more volatile stocks.
So far, this article has been all about how to use and apply the total return formula.
The next section shows the top 10 rated Dividend Aristocrats based on expected total return.
Estimated Total Returns for The Dividend Aristocrats
The top 10 Dividend Aristocrats based on estimated total return are shown below.
Note 1: Valuation return is based only on 10 year historical P/E ratio and current P/E ratio (using adjusted earnings). Cyclical businesses (like ADM, CVX, and XOM) are unfairly penalized here as earnings are depressed resulting in an inflated P/E ratio. A 6 year return to ‘fair value’ time period was used.
Note 2: Growth rates are based on a mix of Value Line estimates, my own estimates, and historical growth numbers.
You can download a spreadsheet of data for all 50 Dividend Aristocrats at the link below. The spreadsheet includes:
- All 50 Dividend Aristocrats
- Valuation, Growth, and Dividend Returns
- 10 Year Historical Average & Current Price-to-Earnings Ratios
- Total Returns
Note: The same limitations discussed in notes 1 and 2 apply to the spreadsheet as well.
Estimating total returns quantifies the assumptions you make about a stock.
Estimated total returns make comparisons across different stocks and investments easier.