In my post on the foundations of a successful investment, I explained why estimating the profits you expect from your investment in today’s terms (present value) is essential. For bonds and other fixed investments, estimating these profits are usually straightforward because their returns percentage is given but for shares/stock, you need a little more work.
Recognizing the Options Available to You
If you want to analyse the benefits you get from investing in shares, two words that you’ll come across often are:
- Growth
- Returns
Although mostly used interchangeably growth and returns are not entirely the same.
Growth: is used to reference the increase in share price. for instance, if you bought a share for $5 and 3 years later it is now $8, we can say your investment has grown by 60%. If you decide to sell your shares then the benefit you get from that investment would be 60%.
Returns: is used to reference share price growth, dividends, and any other benefit you might have gotten from holding the shares.
TLDR
GROWTH = SHARE PRICE GROWTH
RETURNS = SHARE PRICE GROWTH + DIVIDENDS
Note: Not all companies pay dividends and if that’s the case for you then your returns = growth.
Estimating Growth
If you want to estimate the benefits of investing in a company, especially one that pays no dividend i.e your primary avenue for profit is from growth, it’s best to do so with a 5-year outlook to protect you from loss due to market fluctuations. Therefore for this post, I will be focusing on how you can estimate a company’s 5-year growth.
1. The Easiest Way: Use Yahoo! Finance
On Yahoo’s finance platform, you can easily navigate to the analysis page of your company of choice and scroll down to find analyst growth estimates for the next five years.
See the example for Google’s parent company Alphabet below:
That’s it! Now you can apply this estimate in your analysis and calculations.
OR
Find out our to calculate this estimate yourself.
Extrapolation of historical growth
This is based on the idea that the shareholder’s expectations will be based on what has been experienced in the past. An average rate of growth is estimated by taking the geometric mean of growth rates in recent years. The formula for doing this is called Compound Annual Growth Rate, See below:
If we apply this formula to Alphabet shares as in above, for a 5-year estimate we will have:
t = 5
Vfinal(price of shares today-04-Feb-2023 ) = 104.78
Vbegin(Price of shares- 04-Feb-2018) = 52.31
CAGR = 14.9%
Adjusting for Risk
Working with the knowledge that the results you get from applying the CAGR formula are just an estimate, it is then important for you to apply a reasonable percentage based on your confidence level about the company’s future, the industry it’s in, and the economy as a whole.
Let’s say for instance I believe that with everything I know about google right now, I am confident that they can achieve 70% of this growth estimate.
Therefore adjusting for my confidence level, the growth rate I will be working with is: 14.9 X 0.7 = 10.43%
Estimating Benefits Through Returns
As an alternative to using growth estimates many shareholders use profit-based estimates to analyze the benefits they could get from an investment, even though not all profit would trickle down to shareholders, especially when a dividend is not paid. This is still useful in reviewing company performance, analyzing share prices, and making growth predictions.
Calculating Return on Equity
The return on equity ratio is used by shareholders to estimate how efficient a company is in converting its shareholders’ investments into profits. This ratio is used to get a sense of what investors’ returns will be.
The return on equity might be calculated based on the most recent financial statements or as an average of the returns on equity over a period of years.
the formula is:
If you want to apply the return on equity formula for a 5-year estimate, all you have to do is get the ROE value at the beginning and end of the 5 years and apply them to the CAGR formula above.
Summary
The methods of estimating returns on your share investments that I considered in this article are:
- Yahoo! Finance
- Geometric mean growth rate
- Return on investment
With forward-looking estimates such as these, it is important that you acknowledge that accurately predicting the future is not possible (at least not all the time). The purpose of estimating returns is not to give you an exact figure of how much you’ll make from an investment but to provide you with something that can be considered to be within range of the actual figure.
With these estimates in hand, you can now estimate the value of a company’s shares.
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