Morgan Housel, my Foolish colleague from The Motley Fool US, wrote some time ago that "a stock's future returns will equal its dividend yield, plus its earnings growth, plus or minus changes in valuations (earnings multiples). That's really all there is to it."
Most investors that follow the Foolish methodology would agree with him, however his theory that "dividends and earnings growth for many companies can be reasonably projected" has been tested in the ASX market by a couple of prominent companies over the last 12 months.
Share market Returns
As Morgan wrote, there are three basic variables that need to be taken into account when determining the value of a company; its earnings growth, its dividend, and the price to earnings (PE) ratio that it trades at.
Now, let's be clear, it's very difficult to know the PE ratio that a company will trade at as it "reflect[s] people's feelings about the future, swinging between optimism and fear. And there's just no way to know what people are going to think about the future in the future." So let's assume we can't forecast the price to earnings ratio, what about earnings and dividends?
Earnings Forecasts
I'm sure there are thousands of investors out there that make investing decisions based solely on the forecasts of analysts. However, I believe we all need to take a step back and consider the risks before taking their forecasts as gospel.
Example 1: Metcash Limited (ASX: MTS)
Metcash was once considered a reliable dividend stock and predicted by almost every analyst to continue being that way for the foreseeable future. Just 12 months ago analysts expected a total dividend payout 17.1 cents this financial year, representing a 15% yield based on today's price of $1.17, and even six months ago they were expecting 12.5 cents. Today we know that Metcash will not pay a final dividend this year or a dividend at all next financial year as the company attempts to turn-around its struggling operations.
Example 2: Fortescue Metals Group Limited (ASX: FMG)
2014 was a good year for Fortescue. A high iron ore price and swift payment of outstanding debt saw analysts in April 2014 (14 months ago) predict a 2015 financial-year earnings per share forecast of 75 cents and dividend per share forecast of 33 cents. The current consensus forecast? Earnings per share of 9.9 cents and dividend per share of 5.7 cents! Their $80 per tonne iron ore forecast was wrong, however there were very few that saw the plunge to $45 per tonne coming.
Example 3: Woolworths Limited (ASX: WOW)
Woolies is perhaps the highest-profile victim of analysts getting it wrong lately. When the share price was sitting around $38 in mid-2014, analysts forecast a handy 10% increase in earnings per share to around 216 cents in 2015, and similar growth in dividend to 150 cents per share. The well-publicised growth issues have resulted in a 27% fall in the share price to just $27 and earnings per share are now expected to be flat at 195 cents, potentially falling to 190 cents in 2016.
The Lesson?
Charlie Munger, Warren Buffett's investing partner, put it best: "You don't have to be brilliant, only a little bit wiser than the other guys, on average, for a long, long time."
Take your time to assess the risks that a company faces and if that risk is too great then simply don't invest. The worst that can happen is that you'll miss out on some gains, but you'll pass the sleep-at-night test that can cause you trouble when investing in a company you don't really believe in. In addition, there are typically hundreds of companies that perform well over any time period, so hopefully you're investing in a better company instead.
