A Simple Formula To Assess Probabilities Of Stock Returns

John Bogle has written about a simple formula in his book, ” Common Sense on Mutual Funds” to calculate investment return from stocks.

The formula is as follows:

Total return = Fundamental Return + Speculative Return
Fundamental return = Initial dividend yield + Earnings growth over the time period
Speculative return= Change in P/E ratio over the time period.

Total return = Initial dividend yield + Earnings growth over the time period + Change in P/E ratio over the time period

 

Let us now apply to this to a stock from the Indian stock market but you can do it for any stock: Hindustan Unilever

  • Current P/E ratio: 34.81
  • Current dividend yield: 3.04%
  • Earnings growth over the last 5 years: 17.03%
  • Earnings growth over the last 10 years:8.18%

The return you can get from this stock over the next 10 years will depend on the earnings growth over the next 10 years and the P/E at which the stock trades at the end of 10 years.

These are assumptions that we must make. The reason Buffet is so successful is because he knows whether he can make these assumptions in the first place and then makes good predictions. It is not easy. That is why it may be better off investing in index funds. Okay, let me make some assumptions.

  • Earnings growth over the next 10 years=12.5%( average of 17+8)
  • Final P/E ratio=18( average P/E ratio of the NIfty over a long period)
  • This means earnings in 10 years time would be 56.80
  • With a P/E ratio of 18, the stock price would be 1022.4
  • The current stock price is 608.90.
  • This means the annual return over the next ten years would be 5.32% if the above assumptions are true. Dividends are not included. If we include dividends 8.34%.

The answers will change if the assumptions change and that is why stock returns are so hard to predict and the market is so hard to beat.

  • Earnings growth of 17.03%
  • Final P/E ratio of 30
  • This means earnings in 10 years time would be 84
  • With a P/E ratio of 30, the stock price would be 2520
  • The current stock price is 608.9
  • This means the annual return over the next ten years would be 15.28% if the above assumptions are true. Dividends are not included. If we include dividends 18.32%.

If we use the formula:

  • 1st scenario: 12.5%+3%-6.16%= 9.34%( earnings growth of 12.5%, final P/E of 18)
  • 2nd scenario: 17.03%+ 3% -1.24%= 18.79%( earnings growth of 17.03%, final P/E of 30)

If we invest say in bank deposits for 10 years we get a rate of 8.75%. But this is taxed at the normal rate and may be up to 30%. So the return you get is closer to 6-7%.

So you can see, that by investing in HUL even at this high price, if the company does reasonably well, you are better off than investing in a bank deposit and if it does really well, then you have a good chance to make a lot of money.

It is worthwhile to do this kind of scenario analysis and see whether the returns you may get are worth the risk you are taking. You do need to make assumptions about growth rates and P/E ratios in the future but all successful investing is making some assumptions like that.

 

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