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Stock Strategist

Two Buys and a Sell: Dissecting Stock Returns

We look at three components of a stock's expected return.

Much can be learned by taking things apart. If I want a 20% return on a stock, I want to buy the stock for $50 and end up with $60 by the time I sell it. But how realistic is my desired return for any particular stock? One way to try to answer that question is to break down the desired return into its constituent parts. My future return on the stock can come in three ways. The company can grow. The price multiple between my purchase date and the sale date can rise. Or I can collect dividends and earn the return that way.

The way this is usually expressed is:

Return = Earnings Growth + Change in P/E + Dividend Yield.

Expressed crudely and admittedly too simplistically, a growth investor will focus on the first component, a value investor on the second, and an income investor on the third.

Back to my desired return. Let's look at three stocks and ask: How likely am I to actually realize a decent return on the stock?

The Growth Stock: Walgreen
 Walgreen (WAG) recently hit 5 stars for the first time, and given what a high-quality company it is, we took notice. As you can see from the chart below, Walgreen's earnings have risen steadily over the past 10 years. Walgreen has a template for successful stores and just keeps rolling them out in more and more locations. The stock price, however, got a little ahead of the company during the market bubble of the late 1990s, and has since come back into line with underlying corporate growth.

You see this pattern again and again when comparing stock prices and fundamental measures. In the long term, company fundamentals determine the stock price. In the short term, animal spirits hold sway. Company fundamentals are extremely hard to predict, but for some companies--especially those with moats like Walgreen--we can be fairly confident in predicting the future course of the business. Animal spirits, by contrast, are inherently unpredictable, although you can't count the hucksters who'll try and convince you otherwise.

Given that the stock price and earnings have tracked each other over the long term, we shouldn't count on a rise in price multiples to give us our return. But earnings growth is attractive. The bars below the graph track Walgreen's year-by-year earnings growth, and it's been a steady 15%. In the detailed free cash flow projections we use to arrive at our fair-value estimates, we forecast double-digit growth to continue. If we're right, the stock price will tag along, even though it may meander a bit in the process. (The dividend yield of 0.55% will help a bit.)

Other 5-star stocks in this growth group might include  Fastenal (FAST),  CarMax (KMX), and  Microsoft (MSFT)--all companies that are growing nicely, and whose expected stock returns are, we think, attractive because of it. Multiple expansion and dividends would be icing on the cake.

The Turnaround Stock: International Game Tech
As my colleagues Mike Trigg and Sanjay Ayer explained in mid-2005, we think that there's a good chance earnings growth will turn up sharply for  IGT . The company has recently been a victim of its own success: So many casinos bought its cashless slot machines that demand for replacement machines slowed. (It's as if U.S. consumers all bought a new car in a given model year; the next year dealers would have a tough time moving inventory.) The underlying demand for slot machines certainly seems destined to grow, however, and IGT is the dominant supplier.

When we published the article on IGT last year, the stock traded at $28.44 and was 5 stars. Now it's $35 and down to 3 stars. So far, so good.

In this chart, we show the share price graphed against operating cash flow and free cash flow. Although choppy, the stock has generally followed the upward trend in the business. If cash flow picks up, investors in IGT should get some of their return from underlying corporate growth, just as they've done through most of the past 10 years. And if growth does revive, we might also get a reinflation of price multiples, given how much the share price has lagged the business over the past two years.

IGT was (and still is) a classic turnaround story. If the story has a happy ending, investors will earn a return from both rebounding growth and rebounding multiples. The dividend yield of 1.5% also contributes to our expected return.

An even better multiple-expansion story might be  Avon , which is currently 5 stars.

One to Avoid: Chico’s FAS
I could have chosen many examples to illustrate a stock whose future return prospects are slim, in our opinion. We currently have about 530 1-star stocks, and by our definition a 1-star stock is one that will return less than a government bond over the long term.  Chico's (CHS), the clothing retailer, gets the nod.

As you can see from the graph, the stock price has outpaced earnings growth over the past year, and the P/E has been expanding. To earn a decent return on Chico's, you need to assume that the rapid growth continues (EPS growth, although slowing a bit, is admittedly still strong), and the P/E ratio doesn't drop back to historical levels (it's in the mid-40s now, which is higher than at any point in the past 10 years). The company pays no dividend, so that won't help the return. This seems like a losing bet, in our opinion.

Conclusion: Know Where to Expect Your Return
Stock returns have to come from somewhere, and that somewhere is corporate growth, multiple expansion, and dividends. It's a useful exercise to consider the prospects for each of those before purchasing a stock. Unfortunately, the past return of a stock--whether it's been 100% or negative 90%--tells you nothing about the future long-term return of that stock. And as comforting as it is to think that stocks somehow magically return 12% over the long term, there's no guarantee of that, either.

Haywood Kelly, CFA has a position in the following securities mentioned above: KMX, MSFT. Find out about Morningstar’s editorial policies.