Determining the expected return for the share

Equity and equity investments are the last in the order of liability under the Companies Act, i.e., the share is always a risky investment. Equity investors naturally want a return for bearing the risk. 

The equity investor’s return consists of a combination of two components, i.e. changes in the share price and the capital returned to the owners. So far, the equation is quite simple, because it is easy to calculate the total return of each share backwards. However, history is not a guarantee of future.

The value of the company is the present value of future cash flows...

There is a clear consensus in the academic world that the value of the company is the present value of cash flows (DCF). Determining the present value of cash flows requires estimating of future cash flows and determining the market return requirement for the entire estimate horizon.

Comparing the company value resulting from this theoretical framework to its current market price allows the investor to calculate the expected return on the investment. In practice, however, the matter is much more complex.

... but the DCF at best only gives an indication of the expected return

DCF is a beautiful idea, but in practice it is impossible to predict the future cash flows of any company accurately from time to eternity. The required returns also vary considerably in the market, e.g., due to changes in interest rates, the general risk-taking willingness of investors (risk premium) and company-specific business profiles.

Therefore, the DCF even at best only provides an indicative image of the expected return (i.e. a stable and predictable business). In addition, the model does not actually take a position on the delay at which the expected return is expected to materialize but indicates what the value should be now. The time element can of course be ranged by assessing the current market return requirement against the estimated long-term market return requirement and the time required for them to converge.

Importance of the time element in the expected return

The time element is a very critical factor for annual revenue. For example, the realization of a 100% expected return over a three-year period means an annual return of around 26%, while the realization of the same return over 10 years represents an annual return of 7%. The first of these would be a fantastic performance in the long run for any investor. The latter has been a fairly normal long-term index return, which has historically been achievable with time-diversified index investing, in other words with little work. Thus, achieving excess return or better return than the market return requires effort, successful stock picking, risk taking and also timing for individual companies.

Forming the future expected return

Based on the theoretical model described above, we can move towards practice.

Typically, Inderes’ analysts simplify the very theoretical model described above to a shorter, and thus more easily (but not easy), predictable time horizon. At the same time, the basis of the valuation turns from DCF to valuation multiples, although the same logic of the ratio between the expected return and required return is still valid in the background. In this model, the future expected return (i.e. the upside in the share price and annual dividend) is assessed as the sums of the change in earnings growth, dividends and valuation multiples typically at a 1–5-year time span.

1. Earnings growth

Expected earnings growth naturally comes from the estimates and is discussed in previous articles of the Analysis school. We believe that the uncertainty or risk associated with estimated earnings growth is relatively high, since, apart from certain relatively rare exceptions, predicting the future for any longer period is very difficult and, as the delay increases, accuracy is also bound to suffer. Thus, a conservative investor maintains a safety margin in the estimates. However, earnings growth is by definition the most important component of the expected return, as typically the speed of earnings growth affects the acceptable valuation of the share. Thus, changes in the earnings growth rate often generate a "double lever" in forming the expected return.

It also makes sense to use a range for estimates. In practice, when the estimates of the neutral scenario point to an annual earnings growth of 5% for the next three years, making the calculation with, e.g., an annual earnings growth of 3-7% gives a certain safety margin and/or understanding of a scenario where the estimate is not exactly correct (i.e. how much an estimate error pushes the expected return below the required return?).

The role of earnings growth in forming the expected return depends a lot on the investor’s time horizon. In the long term, the return of the share effectively reflects the earnings growth and the best long-term investment targets are companies that constantly increase their earnings. In the short term, changes in the dividend and valuation levels may, however, compensate for negative earnings growth.

2. Dividends

The most predictable component is usually the dividend, because most companies have dividend policies and companies tend to seek predictable repayment of capital that balances out earnings cycles.

The role of dividends in forming the expected return depends significantly on the nature of the investment object. Growth companies generate most of the return from other components, while dividends can play a significant role in the long-term return of slowly growing value companies.

3. Changes in valuation multiples

Changes in valuation multiples is also a difficult component to predict especially in the short term, as the acceptable valuation multiples for a share at any given time depend on the interest level, liquidity level, investor sentiment, earnings growth expectations, and many other factors, even if the risk profile of the company's own business remains pretty much unchanged. Thus, an investor basing their expected return on changes in valuation multiples takes on a market risk that is difficult to predict. 

A change in valuation typically plays an important role in the short-term return on the share. This is also why shares are primarily recommended as long-term investments, as in the longer term, the valuation typically has time to seek its “correct” level over temporary market fluctuations.

Indications of the acceptable valuation level can be sought, e.g., from the company's long-term history and/or peers. A range is also good when determining the acceptable valuation, as determining a justified valuation level for any company is not an exact science. Another essential in determining the valuation multiple component of the expected return calculation is that the valuation level must be calculated from the actual result (LTM or previous year). Otherwise, the earnings growth related to the first year will be calculated twice in the expected return.

The role of the safety margin is also emphasized in terms of valuation multiples and in determining the expected return. The realization of a “this time is different” -based valuation scenario typically involves a significant risk. However, a change in the acceptable valuation may at best be a good booster especially for the short and medium-term return of the share if the investor succeeds in finding a company capable of long-term earnings growth that is valued at an unjustifiably low level before the market sees the company's earnings growth ability.

The sum of these three components gives the expected annual return of the share. By applying ranges, the result is naturally also a range. At Inderes, the bottom of the range is the sum of the bottom end of all three components and the top of the range the sum of the top levels, because the market generally accepts a higher valuation for shares when faster earnings growth prevails and vice versa. As the range shows, determining the expected return is not a science with right and wrong answers, but an indicative assessment of justified scenarios. 

The required return is the counterpart of the expected return

The counterpart of the expected return is typically the required return, which each investor determines themselves based on their own situation (e.g. safety margin requirement). Typically, the required returns for shares are between 6% to 20%, where the bottom describes a predictable operator and the top a developing company that burns cash. For most listed companies, the required return is 8-10% under normal circumstances, which, in our opinion, gives the investor an idea of what their required return should be.

A higher required return gives the investor a safety margin against forecasting errors but, on the other hand, makes it considerably harder to find good investment targets if the required return is too high.

Time horizon for expected return

For what time horizon should the expected return be determined? This is the million-dollar question, which every investor will have to answer for themselves. The situation also requires balancing, as the predictability of the result is generally reasonable in the short term of at most one year, but on the other hand, a significant part of the return in the short-term comes from changes in the valuation (i.e. market risk is high). On the other hand, on a 5-year horizon the risk in the earnings estimates of almost any company is significant (e.g. in the past 5 years we have seen the industrial downturn in fall 2018 and recovery from it, the COVID crisis, recovery driven by stimulus, supply chain and inflation problems, and Russia's attack on Ukraine). Therefore, stretching the time horizon significantly also causes its own difficulties.

Thus, we believe that the smart approach is to outline the expected return for 1 year, 3 years and beyond, while focusing on the medium term. In this context, the general situation of the stock market and its expected direction should also be considered, as the horizon accepted by the market may vary considerably in the same object, e.g., as willingness to take risks changes.  One should also outline where the expected return will focus on. For example, in companies in the investment stage, earnings growth can be expected within a few years, which markets typically start to price somewhat in advance. In this type of scenario, the expected return can be tail-heavy and therefore risky. Similarly, for an object with high dividends and a low valuation, the expected return may be front-heavy, while the long-term return outlook without earnings growth is weak. For this type of object a shorter horizon is probably more effective. 

Expected return through examples

The investor assumes that company X's EPS will rise from today’s EUR 1 to EUR 2 in the next three years. Currently the company’s P/E is 20x, i.e. the share value is EUR 20. However, the investor assumes that such a high P/E is no longer realistic in three years' time, as at some point the company’s earnings growth will slow down. Thus they calculate that a P/E of 15x would be a realistic price for the share. This means the expected value of the share is EUR 30 in three years' time, i.e. +50% or around 14% per year. In this example, dividends are excluded for simplicity but can be added to the calculation.

However, if the investor paid only EUR 10 for the share today, their expected return would be +200%. Which would be 44% per year. On the other hand, if they manically buy the share at EUR 30, the expected return is zero. The higher the price you pay for the share the weaker the future expected return is.

Let us imagine a company with a constant result that is always at the same level. When the result does not change, the investor's return depends entirely on the price at which they buy the share. If they pay for the share with a P/E ratio of 10x, the expected return is 10%. If the P/E is 20x, the expected return is only 5%, etc. This illustrates the role of earnings growth in the long-term expected return of the share.