What to Expect from Your Stocks

Many people consider investing terribly complex. Wouldn't it be beautiful if there was a simple way to know what kind of ballpark return you could expect from your stocks based on just two metrics? Thanks to the principles behind a valuation model attributed to finance professor Myron J. Gordon at the University of Toronto, such simplicity is possible.

The Gordon Growth Model and Expected Return
One of the most well-known and simple ways to figure out what a stock is worth is through the simple Gordon Growth dividend discount model. This model suggests that the price of a stock is equal to next year's expected dividend per share divided by investors' required rate of return minus the expected growth rate in dividends. For equation lovers: P = D/(k-g).

While screening a stock to find a potential winner, investors may be interested to know the average return they should expect from it. Taking the Gordon Growth equation above and using a little algebra, we can solve for an investor's required/expected rate of return: k = D/P + g. Thus, an investor's expected return is the sum of two parts: the dividend divided by stock price (a term known as the dividend yield) and the expected growth in dividends forever. Because dividend growth is highly correlated with and dependent on earnings growth, investors can substitute earnings growth for dividend growth in the "g" part of the equation. A recent article from Morningstar stock analyst Curt Morrison recently highlighted what investors should expect from the stock market going forward using something similar to this model.

The Gordon Growth Model in Action 
Using the assumptions in Morrison's article in our simple Gordon Growth Model we can estimate what investors should expect from the S&P 500 going forward. Next year's dividend yield is estimated at about 1.9%, and earnings growth (ignoring inflation) is estimated to be 1.25% going forward, which Morrison pointed out is consistent with what stocks produced during the last 130 years. Using these assumptions in our k = D/P + g model, investors should expect about 3.15% (1.9% + 1.25%) growth annually, before inflation. This is much lower than the comparable, 6.90% pre-inflation returns that investors enjoyed during the 75 years ended in 2001, as mentioned in Morrison's article. However, before overwhelming your broker with sell orders, let's examine the flexibility of this model and its components.

A Little Magic and the Cash Return Ratio 
There are obvious limitations to using a simple model like the Gordon Growth, including but not limited to the assumption of dividend yield as the key driver of value. At Morningstar, we are not as concerned about the dividend yield as we are about how much cash companies generate that could potentially be paid out to shareholders through dividends or stock buybacks. This measure is free cash flow. In order to make the model a little more robust without making it too complex, we can substitute free cash flow (FCF) for dividends in our equation. Also, instead of focusing only on the market price of the stock, we can substitute a company's enterprise value (EV), which is the market value of stock + debt - cash. Think of enterprise value as what you would have to pay to own the entire company outright--you would purchase all of the stock and pay off the debtholders but also receive whatever cash the company is holding. Substituting these new terms in our equation, our expected return becomes: k = FCF/EV + g.

At Morningstar, we call free cash flow to enterprise value the Cash Return--the annual cash yield you would receive on your investment if you bought the entire company. We like this ratio because it's a simple measure of the key driver of investment returns and shareholder value: free cash flow. For a given company, this ratio is found on the Morningstar Stock Report under Valuation Ratios. Click on the tab marked Yields to see a calculation of Cash Return.

Practical Use of the Modified Model 
Using the revised model, let's revisit the question of what investors can expect from the S&P 500 going forward. From our databases, we found that the average Cash Return (FCF/EV) for the S&P 500 is around 3.5%. Using the same 1.25% growth rate in earnings as noted above, we estimate that investors can expect annual returns of 4.75%, ignoring inflation, going forward. Although still below the historic average of 6.90%, this modified model paints a little brighter picture than the plain Gordon Growth dividend discount model. However, the 4.75% expected return for the S&P 500 is relatively lackluster compensation, which provides even more incentive, in our opinion, for investors to find individual stocks that can outperform the market as a whole.

The beauty of the model is in its application for screening and monitoring individual stocks in terms most can understand: an expected return. By focusing on the combination of just two variables, the Cash Return and expected growth rate, investors can use this simple model to screen for returns that excite them, which can lead to further research. For example, using  this screen in Morningstar's Premium Stock Screener, we found that the expected return for  Fair Isaac  (FIC) with a Cash Return of 10.5% and decent growth prospects looks promising. Also,  Nokia (NOK), with a Cash Return of 12.5%, doesn't need much growth for its return to look attractive relative to the market. Investors can also monitor their holdings by reassessing their expectations of the Cash Return and earnings growth, and if the calculated expected return begins to drop, it may be a good time to look deeper.

As with all analysis, the devil is in the details, and investors should never rely on any single ratio or calculation to make an investment decision. However, the Gordon Growth Model and its modified cousin can be a great tool for evaluating investments in terms of what rate of return investors can expect from companies' stock.