What a Red-Hot Stock Market Teaches Us About Shareholder Returns
It’s the summer of 2021, and the market is on a tear. As of 7/27/21, the Standard and Poor’s 500 Index (a basket of 500 large company stocks) is near a record high- up nearly 36% in the last 12 months.
So, if you’re an investor, how much are you earning on your stock investments? After all, you’re investing to save for a house, or to plan for retirement. Is your investment earning a reasonable rate of return?
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Generally speaking, there are three ways to earn a return on a stock.
- Price appreciation: You profit from selling the stock for more than the cost
- Cash dividend: The company pays you a cash dividend, which is a share of company earnings
- Stock dividend: You receive a dividend in the form of additional stock, and you can benefit from price appreciation and/or a cash dividend on the new shares
The biggest driver of a stock’s value is the earnings per share (EPS).
Understanding earnings per share (EPS)
Earnings per share is defined as (Net income available to common stock) / (average shares of common stock outstanding). In other words, how much did the company earn on each share of common stock?
Not all of company net income may be available for common shareholders. Firms that issue preferred stock may set aside net income to pay a preferred dividend before a common stock dividend (hence the term “preferred” stock).
Let’s assume that Premier Manufacturing earns $5,000,000, and that the average number of common stock shares outstanding is 2,000,000 shares. EPS is ($5,000,000 / 2,000,000 shares), or $2.50 per share.
So, is $2.50 a good, bad, or average return?
The answer is found in the earnings yield:
Earnings yield = (Earnings per share) / (Market price of common stock per share)
If Premier’s common stock price is $60 per share, the earnings yield is:
($2.50 Earnings per share) / ($60 Market price), or 4.2% (with rounding).
Here’s the challenge of investing when markets are near an all-time high: When the price you pay for a stock is higher, the earnings yield is lower. Essentially, you’re paying a higher amount of each dollar of earnings.
If there are more common stock shares outstanding, the earnings per share will also be lower.
How dilutive securities impact EPS
Dilutive securities increase the number of common stock shares outstanding. Here are two common examples:
- Convertible bonds: Bonds that allow the owner to convert the bond into shares of common stock
- Stock options: A security that allows the holder to purchase shares of common stock at a specific price
If Premier has dilutive securities outstanding, investors will want to know the dilutive earnings per share. Using dilutive EPS, every share that can be converted into common stock IS converted. It’s a “worst case scenario” for EPS.
There are several ways to measure the value of a stock dividend.
Measuring the value of a dividend
Dividend yield reports the rate of return on a dividend, based on the current market price of the stock:
Dividend yield = (Annual dividend per share) / (Market price of common stock per share)
In this example, Premier pays a $1.25 dividend when the stock price is $60 per share. The dividend yield is ($1.25 annual dividend) / ($60 market price), or 2.1% (with rounding). Think about it this way: If an investor purchases Premier at $60 per share, they are “buying” a 2.1% dividend return.
Finally, the dividend payout ratio points out the percentage of company earnings paid as a dividend:
Dividend payout ratio = (Common stock dividend) / (Earnings available to common shareholder)
Premier’s dividend payout ratio is ($1.25 dividend) / (2.50 EPS), or 50%.
To compute the shareholder return on a stock:
(Increase in common stock price + Annual dividend per share) / (beginning common stock price).
Compare all of these calculations to historical trends, and to industry averages.
Good luck!
Ken Boyd
Author: Cost Accounting for Dummies, Accounting All-In-One for Dummies, The CPA Exam for Dummies and 1,001 Accounting Questions for Dummies
(email) ken@stltest.net
(website and blog) https://www.accountingaccidentally.com/
(you tube channel) https://www.youtube.com/user/kenboydstl