First published July 16th, 2016 by Ben Reynolds. Updated on August 29th, 2022 by Bob Ciura for SureDividend
The goal of rational investors is to maximize total return under a given set of constraints.
Constraints include:
- Risk tolerance
- Current income needs
- Ethical concerns (no tobacco stocks, as an example)
This article shows exactly how to calculate expected total returns.
In this article
Video Analysis
The following video provides a visual tutorial on how to calculate expected total returns, using the Dividend Aristocrat Coca-Cola (KO) as an example.
Note: The Dividend Aristocrats are an elite group of 65 stocks in the S&P 500 that have paid rising dividends for 25+ consecutive years.
What Is Total Return?
Total return is the complete return of an investment over a given time period. It includes all capital gains and any dividends or interest paid.
Total return differs from stock price growth because of dividends. The total return of a stock going from $10 to $20 is 100%.
The total return of a stock going from $10 to $20 and paying $1 in dividends is 110%.
It may seem simple at first glance, but total returns are one of the most important financial metrics around…
How-To Calculate Total Return
- Find the initial cost of the investment
- Find total amount of dividends or interest paid during investment period
- Find the closing sales price of the investment
- Add sum of dividends and/or interest to the closing price
- Divide this number by the initial investment cost and subtract 1
An example using the numbers from the dividend case in the ‘What Is Total Return’ section is below:
- $10
- $1
- $20
- $20 + $1 = $21
- $21 / $10 – 1 = 110%
How-To Estimate Future Total Return
Calculating total return after the fact is simple.
There’s money to be made in accurately estimating expected future total returns in the stock market.
To understand how to do this for stocks, we have to break total return down into its components.
- Dividends
- Change in share price
Change in share price comes from 2 sources.
- Change in earnings-per-share (or less commonly book value, revenue, etc.)
- Change in price-to-earnings multiple (or other valuation multiple)
Therefore, the 3 aspects of total return for stocks are:
- Dividends
- Change in earnings-per-share
- Change in price-to-earnings multiple
The formula for expected total return is below:
Expected total return = change in earnings-per-share x change in the price-to-earnings ratio
Note: We calculate expected total returns using the 3 aspects of total return for more than 700 securities in The Sure Analysis Research Database.
The rest of this article shows how to estimate expected total returns with a real-world example.
We will estimate future returns for Coca-Cola (KO) over the next 5 years.
Coca-Cola is used as an example because it is a relatively simple, predictable business. This makes it a good choice for learning how to calculate expected total returns. With that said, this method can be applied to any stock investment.
The further out in time one estimates, the less reliable the estimate. Estimates of Coca-Cola’s return over 1 year will likely be more accurate than estimates over 10 or 20 years because more can change in 10 or 20 years than in 1 year.
Estimating Valuation Multiple Changes
Coca-Cola stock currently trades for $63 per share. The company is expected to generate adjusted earnings-per-share of $2.45 for 2022, for a price-to-earnings ratio of approximately 25.7.
In the past 10 years Coca-Cola had an average price-to-earnings ratio of 22.2.
Meanwhile, S&P 500 stocks appear to be overvalued from a historical perspective at current levels.
- S&P 500 price-to-earnings ratio of 20.3
- Historical average price-to-earnings ratio of 14.9
There are 2 questions surround Coca-Cola’s price-to-earnings ratio:
- Will it maintain its historical premium to the market in 5 years?
- Will the market still be overvalued in 5 years?
When one makes projections, one should always err on the side of conservatism.
Coca-Cola’s core soda business is experiencing headwinds in developed countries that are likely to persist indefinitely. On the other hand, the company is a market leader that still has growth potential internationally and with its still beverages. Given all these factors, we believe a price-to-earnings ratio of 23 is appropriate for Coca-Cola stock.
The question of whether the market as a whole will be overvalued in 5 years is more difficult to answer.
Here are 3 different scenarios for the next 5 years:
- Market reverts to historical price-to-earnings ratio of 14.9
- Market maintains its current overvalued status at 20.3
- Market mediates to a price-to-earnings ratio of around 20
I believe that all 3 of these scenarios are about equally likely. This is just guessing at the future however. Estimating a reliable price-to-earnings ratio into the future is error-prone.
Still, since KO stock is trading above our fair value estimate, we expect that valuation multiple changes will be a drag on Coca-Cola’s future returns.
If the P/E multiple declines from 25.7 to 23 over the next five years, it would reduce total returns by 2.2% per year over that time period.
The steps to calculate valuation multiple changes are below:
- Find current price-to-earnings ratio
- Estimate expected future price-to-earnings ratio
- Calculate compound annual growth rate of price-to-earnings ratio
Estimating Expected Growth Rate: Underlying Business Growth
Growth should be estimated on a per share basis.
Why? Because share buybacks and issuances matter. A brief example is below:
Imagine a business generated $1,000,000 a year and has 4 owners. This business is valued at a 10x earnings multiple. The whole business is worth $10,000,000. Your share of the business is worth $2,500,000 (lucky you!).
Now imagine that one of the owners wants to be ‘bought out’. The business uses cash on hand to buy out this owner. There are now only 3 owners left, and the business is still making $1,000,000 a year and has a 10x multiple.
Your share of the business has now gone up to $3,333,333 because you own 33% of it instead of 25%.
If new shares were issued, the opposite effect would have occurred; your shares would be worth less. Investors should always estimate growth on a per share basis.
Growth comes from 2 places for public businesses:
- Share repurchases
- Underlying business growth
We will assume currency fluctuations will be flat over the remainder of Coca-Cola’s 5 year projections. The company has a number of favorable growth prospects working for it, as well as negative soda trends working against it in the developed world.
We expect the company to continue growing EPS at around 6% a year going forward. This plus the company’s -2.2% per year price-to-earnings ratio compression means we are at expected total returns of around 3.8% a year before dividends.
Estimating Dividend Payments
Coca-Cola currently has a dividend yield of 2.7%. The quick and (mostly) correct way to find the amount of return dividends will add to total return is to simply add the current dividend yield to our return numbers so far.
Adding Coca-Cola’s current dividend yield of 2.7% to the company’s 3.8% returns we’ve calculated so far gives us an expected total return of 6.5% a year.
Adding current yield does not factor in dividend growth. Coca-Cola is one of only 45 Dividend Kings; stocks with over 50 consecutive years of dividend increases. The company’s dividend will very likely continue to grow.
As mentioned earlier, we expect dividend payments (not on a per share basis) to grow in line with earnings, at 6% a year.
Putting It All Together
When you look at where total returns will actually come from you can better estimate how much you expect to make from an investment.
This allows you to more accurately compare investments to each other.
When we analyzed Coca-Cola, we came up with an estimated total return of 6.5% a year. You may think the company will grow earnings at 8% a year instead of 6%, or that its fair price-to-earnings ratio is really 30. This will increase expected total returns. It’s important to make your judgement as sober as possible when comparing total returns of businesses.
Update from 2022: With the benefit of hindsight, we can see how close the expected total return calculations were to reality. Looking back, the assumptions at the time this article was first published appeared valid. From August 1st, 2016 (the start of the first month after this analysis was written) through July 31st, 2021 (for a full 5 years), Coca-Cola stock generated total returns of 9.1% on an annualized basis. This was nearly 3 percentage points ahead of our estimate from 2016.
The ‘quick and easy’ way to find total return is to:
- Calculate return from change in price-to-earnings multiple
- Add in current dividend yield
- Add in expected business growth rate on a per share basis
This method will provide very similar estimates without nearly as much ‘number crunching’ as in the example above.
Total return is one of (if not the) most important financial metrics around. Total returns (through growth and dividends) are an important part of The Sure Dividend Investing Method.
This article was first published by Ben Reynolds for Sure Dividend
Sure dividend helps individual investors build high-quality dividend growth portfolios for the long run. The goal is financial freedom through an investment portfolio that pays rising dividend income over time. To this end, Sure Dividend provides a great deal of free information.
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