The potential return for any investment over a period of years can be determined by adding anticipated income (from dividends, interest, rents, or other sources) to the future value of the investment and then subtracting the investment’s original cost. The investor using fundamental analysis can obtain the figures needed to construct the expected stream of future earnings for a company from a variety of sources. For example, you can use estimates for earnings and dividends gathered from large investment data firms such as Value Line or Standard & Poor’s, an individual stock analyst’s projections, or figures from the company itself, or you can create your own numbers.
Add Up Projected Income and Price Appreciation Table 14.1 illustrates how to sum up the projected income and price appreciation. You can convert these figures into a potential rate of return by calculating the approximate compound yield, as shown in Equation (14.2). This figure can then be compared with returns on other investments.
Add Up Projected Income and Price Appreciation Table 14.1 illustrates how to sum up the projected income and price appreciation. You can convert these figures into a potential rate of return by calculating the approximate compound yield, as shown in Equation (14.2). This figure can then be compared with returns on other investments.
Example: Running Paws Cat Food Company Based on a recommendation from his stockbroker, Martin Crane, a Seattle resident, is considering Running Paws Cat Food Company as a potential investment. Martin figures that the company’s stock might provide a better return than inflation and income taxes for about five years. He has determined the following information about this stock investment: It is currently priced at $30 per share, its most recent 12-month earnings amounted to $2.40 per share, and the cash dividend for the same period was $0.66 per share.
Martin began the task of projecting the future value of one share of the stock by using the earnings per share information. He first calculated the P/E ratio to be 12.5 ($30 $2.40). Next, as illustrated in Table 14.1, Martin applied a 15 percent rate of growth estimate (the same rate that occurred in previous years, according to Running Paws’ annual report) for the earnings per share for each year ($2.40 x 1.15 = $2.76; $2.76 x 1.15 = $3.17; and so forth). Using a P/E ratio of 12.5 (the same as the current ratio), Martin estimated the market price at the end of the fifth year to be $60.38 (12.5 x $4.83). This calculation gives a projected net appreciation in stock price over five years of $30.38 ($60.38 minus the current price of $30).
Martin began the task of projecting the future value of one share of the stock by using the earnings per share information. He first calculated the P/E ratio to be 12.5 ($30 $2.40). Next, as illustrated in Table 14.1, Martin applied a 15 percent rate of growth estimate (the same rate that occurred in previous years, according to Running Paws’ annual report) for the earnings per share for each year ($2.40 x 1.15 = $2.76; $2.76 x 1.15 = $3.17; and so forth). Using a P/E ratio of 12.5 (the same as the current ratio), Martin estimated the market price at the end of the fifth year to be $60.38 (12.5 x $4.83). This calculation gives a projected net appreciation in stock price over five years of $30.38 ($60.38 minus the current price of $30).
To project the future income of the investment in Running Paws the anticipated cash dividends Table 14.1 shows that Martin estimated a 15 percent growth rate in the cash dividend ($0.66 x 1.15 = $0.76; $0.76 x 1.15 = $0.87; and so forth). Adding the projected cash dividends over five years gives a total of $5.11. Martin obtained the potential return for one share of Running Paws over five years by adding anticipated dividend income ($5.11) to the future value of the investment ($60.38) less its original cost ($30.00), for a result of $35.49 ($5.11 + $30.38). Thus, Martin has projected that $30 invested in one share of Running Paws will earn a potential total return of $35.49 in five years.
The question now becomes, what is the percentage yield for this dollar return?
The question now becomes, what is the percentage yield for this dollar return?
The approximate compound yield (ACY) provides a measure of the annualized compound growth of any long-term investment. You can determine this value by using Equation (14.2). The calculation requires use of an annual average dividend rather than the specific projected dividends. In this example, the annual average dividend of $1.02 is computed by dividing the $5.11 in dividend income by five years. Substituting the data from Table 14.1 into Equation (14.2) and using the average annual dividend figure results in an approximate compound yield of 15.7 percent on the potential investment in one share of Running Paws stock for five years. (This formula can be found on the Garman/Forgue website.)
Compare the Required Rate of Return with the Potential Rate of Return on the Investment
Compare the Required Rate of Return with the Potential Rate of Return on the Investment
Now the moment of decision making is at hand. You compare the estimated required rate of return on an investment (given its risk) with the investment’s potential projected rate of return. In our example involving Running Paws Cat Food Company, the risk suggested a required rate of return of 14.0 percent. The investment’s potential rate of return was projected to be 15.7 percent, which suggests that Running Paws is a good buy for Martin at the current selling price of $30 that is, the stock is underpriced. Once armed with projected rate of return information for an investment, you can compare it with other investments.
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