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Understanding the simple maths of share ownership

Knowing the drivers of a share's total returns can help you make better investment decisions
Understanding the simple maths of share ownership

The concept of total return and how it is achieved is of great benefit to investors in individual shares. By understanding the make-up of past returns, investors can gain an insight into likely future returns and make better investment decisions.

In bull markets it often seems that the price you pay for shares does not matter. But the price you pay ultimately determines the return you get from your period of ownership. As paying too much increases the risk of losing money. By knowing the drivers of past returns, investors can better weigh up the potential future returns and risks of share ownership.

Here, we look into the drivers of total returns from owning shares, how to calculate them and how to use the information from them.

 

The simple maths of share ownership

When you buy a share the amount of money that you will ultimately make or lose is determined by two – and only two – things:

  • The change in the share price between when you buy and sell the share.
  • The dividends that are paid to you while you own it.

Added together these two things make up your total return from owning a share. 

Total return from a share = Change in share price + total dividends received

Let’s say you buy a share for 100p. You own it for five years and then sell it for 150p. During that time, you have also been paid an annual dividend of 5p a share, giving you 25p of dividends in total. Your total return from owning the share is:

  • The change in share price of 50p (the 150p you get from selling less the 100p you paid for it).
  • 25p of dividends - five years of 5p per share paid.
  • A total gain of 75p (50p + 25p) or 75% (75p/100p).

When you are investing you should always keep coming back to this simple sum. Every bit of research that you do on a company should boil down to two very basic questions:

  • What does it mean for the profits of the company and will it eventually be reflected in the share price or is it already priced in?
  • Will it change the size of dividends that a shareholder will receive?

Anything you do that isn’t helping to ultimately answer these questions is essentially time wasted. So let’s have a look at these two bits separately.

 

The crucial difference between share prices and dividends 

One of the most important things to understand about the returns from shares is that they are different. You need to be very mindful of this when you are investing.

Share prices can make you very rich if they have gone up a lot by the time you decide to sell. However, gains can be taken away very quickly if a company hits tough times or the stock market crashes. 

Dividends are different. Once they have been paid they cannot be taken away from you. If you don’t like the risk of losing money then investing in shares that pay big dividends can be a less stressful way to make money over the long run, but you are unlikely to make stellar returns.

This is why it can pay to be wary of buying shares in companies where the share price has gone up a lot faster than its profits and the valuation is high. This may not have been a concern in recent times, but the higher a valuation goes, so does the risk of losing money because there is a lot of potential for the share price to fall if things do not turn out as well as people previously thought.

The past is not always a guide to the future, but knowing where the returns of a share have come from can be a very powerful guide to working out what the future might bring and the risks you might be taking on.

 

How share prices are determined

Share prices are no different to any other prices. They are determined by the forces of demand and supply. When a company is very popular with investors its share price tends to go up. It tends to fall when it is out of favour and struggling. 

The famous investor Benjamin Graham summed up the workings of the stock market very well. He said in the short run it was a voting machine based on popularity, where valuation doesn’t seem to matter, but in the long run it was a weighing machine where share prices would ultimately reflect the real value of a business which is based on the expectations of its future profits and cash flows.

In the meantime, share prices can drift a long way from their true or intrinsic value – they can be undervalued or overvalued. Trying to work out whether this is the case is not always easy and is far from an exact science.

In theory, the market value of a company and its share price are determined by two things:

  • Its future profits and cash flows.
  • The value attached to those profits or cash flows. This can be calculated by estimating them and discounting them back to a value in today’s money, but a shortcut is often expressed by a multiple of them such as a price/earnings (PE) ratio. Other common valuation shortcuts are dividend and free cash flow yields.

So share prices change if:

  • profits or cash flows change or expectations of future profits change
  • stock market valuations change.

 

Dividends received

Now let’s look at the dividend part of the total return from a share. This is a lot more straightforward. To pay a sustainable dividend a company needs to be profitable and have enough spare cash (free cash flow). It does not have to pay a dividend to shareholders. Instead, profits and cash flows can be retained in the business and invested with the hope of making higher profits and cash flows in the future.

So the amount of dividend a shareholder will receive will depend on a company’s profitability and how much of those profits the directors want to pay out.

 

Thinking in terms of total returns and investment risk

Focusing on total returns really helps to focus your thinking when you are researching a company. What it forces you to do is to direct your attention on to the only two things that really matter:

  • The outlook for future profits. These will determine both the share price and the size of dividend payments.
  • The valuation of the shares. What you pay for them will have a large bearing on how much money you will ultimately make or lose.

The approach also gets you to think a lot about the risks you are potentially exposing yourself to. These are:

  • Business risks – whether a company can grow and hang on to its profits. This depends on things such as how good its products are and how much competition it faces.
  • Share price risk – whether you are paying too much for the shares. Buying shares with high valuations (such as a high PE ratio) can be more risky than buying shares with lower valuations. This is not always the case, as paying what looks like a high valuation for a really good business has delivered excellent long-term results. That’s not the same as saying that a good business is a buy at any price.

If a company’s profits stand a good chance of growing in the years ahead then you can begin to see how you might end up making money from owning the shares. Higher profits could cause the share price to go up and see you being paid a growing stream of dividend payments.

However, if those shares are too highly priced and the company fails to live up to lofty expectations then even if profits and dividends increase you could still end up losing money – sometimes a lot of money – if the valuation attached to them causes the share price to fall.

By working out what has made up the total return of a share in the past, you can start to weigh up whether you might make or lose money by buying the shares today. 

I am going to show you examples of four different shares and how they have made or lost money in the past. By doing this, you can learn a great deal that then helps you ask some important questions about how the shares might perform in the future.

 

Microsoft - Profits growth and a higher valuation

It’s hard to believe looking at Microsoft (US:MSFT) today that a decade ago it was very unloved with investors seriously questioning its future. You could have picked up the shares for less than 10 times the previous 12 month’s earnings per share (EPS).

 

Since then its profits and share prices have surged and total returns to shareholders have been stellar. But how have they been achieved? It’s fairly easy to work this out.

Dividends are easy. It’s just the total amount of dividends that have been paid over a time period. In the case of Microsoft, shareholders have received $13.92 of dividends per share over the past 10 years. The share price change has delivered the bulk of the returns to shareholders having increased by just over $220 per share – or just under 900 per cent.

 

Microsoft: Shareholder returns over the past 10 years

Share price 10y ago ($)

24.69

 

EPS 10y ago($)

2.53

 

PE 10y ago

9.8

 

Share price today($)

245.2

 

TTM EPS ($)

7.35

 

TTM PE

33.4

 

Total Returns:

$

%

Change in share price

220.5

893.0%

Dividends received

13.92

56.4%

Total gain or loss

234.4

949.4%

Explanation of total returns

  

Change in profits

47.0

20.1%

Change in valuation

173.5

74.0%

Change due to share price

220.5

94.1%

Dividends

13.92

5.9%

Total

234.4

100.0%

Source: Microsoft/Investors’ Chronicle

 

Share price changes can be broken down into changes from profits and changes in valuation. To work out the change due to profits you take the change in EPS and multiply it by the PE ratio when the share was bought.

Microsoft’s EPS has increased by $4.82 to $7.35. Multiply this by the PE 10 years ago of 9.8 and you get a gain of $47.

To explain the change due to valuation you take the current EPS and multiply it by the change in the PE ratio.

In this case, $7.35 x (33.4-9.8) 7.35p x 23.6 = $173.5. 

Add these two changes together and you will see the total change in the share price explained: $47+$173.5 = $220.5.

We can now go further and work out that just over 20 per cent of total return ($47) has come from higher profits with nearly three-quarters of it coming from an increase in the PE ratio ($173.5). Dividends have contributed very little.

If you had owned Microsoft shares for the past decade you would no doubt be very happy. Looking to the future, it is unlikely that such a big and favourable uplift in its stock market valuation will happen again. This suggests that the bulk of returns is going to have to come from profit growth.

If Microsoft grows its earnings by 10 per cent a year for the next decade and its PE ratio stays the same then its shares will be worth $635, which would be a very good result. The risk is that the valuation attached to its profits falls perhaps due to rising interest rates or higher inflation. A PE of 20 times with 10 per cent earnings growth for a decade would give a future share price of $381 – a big difference.

By going through this exercise, you can understand why many people think that future returns from shares such as Microsoft will be lower than they have been in the past.

Returns that have been driven primarily by big changes in valuation are not uncommon in today’s stock markets. An even more extreme example can be seen in the total returns from the shares of the UK-based flavours and fragrances business Treatt (TET).

 

Treatt: Improving outlook gets a big valuation kicker

Treatt: Shareholder returns over the past 5 years

Share price 5y ago (p)

177.5

 

EPS 5y ago(p)

12

 

PE 5y ago

14.8

 

Share price today(p)

1205.0

 

TTM EPS(p)

22.2

 

TTM PE

54.3

 

Total Returns:

p

%

Change in share price

1027.5

578.9%

Dividends received

25.75

14.5%

Total gain or loss

1053.3

593.4%

Explanation of total returns

  

Change in profits

150.9

14.3%

Change in valuation

876.6

83.2%

Change due to share price

1027.5

97.6%

Dividends

25.75

2.4%

Total

1053.3

100.0%

Source: Treatt/SharePad/Investors’ Chronicle

 

Here, more than 83 per cent of its total return over the past five years has come from an increase in its PE ratio. Its current high valuation will lead some investors to believe that its shares are now very overvalued.

 

This may be the case, but it could be that the market is right and that the company’s future prospects are so good that they will transform the profitability of the business. That said, what level of profits does it have to be capable of making to make high returns from the current share price? A lot of good news looks to be priced in.

 

SSE – making a return from dividends

The big money from share ownership usually comes from big share price increases, but there are some cases when dividends make up the bulk of your returns. 

These dividends can be reinvested to buy more shares, which in turn can produce more dividend income and boost returns. In the interest of convenience and simplicity I have not assumed any dividend reinvestment when calculating returns.

Energy utilities such as SSE (SSE) have paid out chunky dividends to their shareholders over the past decade without seeing much in the way of share price growth. 80 per cent of SSE’s total shareholder return of 82.8 per cent over the past decade has come from dividends. This is a lot less than many shares but not too shabby nonetheless and will have fitted in well with the needs of income investors and those who are more risk-averse.

The change in the valuation as represented by the dividend yield has been small. If the current dividend was valued at a yield of 5.44 per cent as it was a decade ago the share price would be 1,478p. The slightly lower current yield of 5.25 per cent has added 52.5p in returns.

 

SSE: Shareholder returns over the past 10 years

Share price 10y ago

1313

 

TTM DPS(p) 10y ago

71.4

 

Dividend yield 10y ago

5.44%

 

Share price today

1531.0

 

TTM DPS(p)

80.4

 

TTM dividend yield

5.25%

 

Total Returns:

p

%

Change in share price

218.0

16.6%

Dividends received

869.3

66.2%

Total gain or loss

1087.3

82.8%

Explanation of total returns

  

Change in dividends

165.5

15.2%

Change in valuation

52.5

4.8%

Change due to share price

218.0

20.0%

Dividends

869.3

80.0%

Total

1087.3

100.0%

Source: SharePad/Investors’ Chronicle

 

If you are looking to buy shares in SSE today, then clearly the sustainability of its profits and future dividends are likely to be your main concern. Can it invest enough in new energy projects such as wind farms to grow profits and will energy regulators reduce the future profits of its energy networks?

 

Fevertree: The dangers of paying too much. Falling profits and a lower valuation

Soft drinks company Fevertree (FEVR) is a classic example of a momentum share that gets pushed to higher and higher valuations on the expectation of upgrades to profit forecasts. Buoyant trading and higher profit forecasts saw it share price surge between 2016 and September 2018 with a very high valuation.

The company hit a bit of a growth plateau before Covid-19 decimated its profits. This has seen investors who bought at the top and hold on nursing some significant losses.

 

Fevertree: Shareholder returns since 2018 share price peak

Share price peak 2018 (p)

3956

 

TTM EPS(p)

44.24

 

TTM PE

89.4

 

Share price today

2586

 

TTM EPS(p)

36.7

 

TTM PE

70.4

 

Total Returns:

p

%

Change in share price

-1370

-34.6%

Dividends received

30.77

0.8%

Total gain or loss

-1339

-33.9%

Explanation of total returns

  

Change in profits

-672.4

50.2%

Change in valuation

-697.6

52.1%

Change due to share price

-1370.0

102.3%

Dividends

30.77

-2.3%

Total

-1339.2

100.0%

Source: Fevertree/SharePad/Investors’ Chronicle

 

The decline in its share price can be explained almost equally between a fall in profits and a decline in valuation. Dividends received have not really cushioned this blow.

A decline in valuation, such as a fall in the PE ratio or similar multiple, is often referred to as multiple compression. Just as an expansion in valuation can turbocharge returns when times are good, the process can work in reverse when times are tough.

Highly valued shares imply high expectations of future profit growth. If the company fails to deliver or investors think it will do so then multiple compression represents a big risk to shareholders.

Fevertree’s profits should recover as pubs and bars reopen, while its overseas business has shown some promising results. However, even if it hits current 2023 EPS forecasts of 61.7p, the shares would still trade on a PE of 41.9 times, which is still lofty by most people’s standards and shows that they are still quite a risky proposition with little room, if any, for disappointment.