Where do Stock Market Returns Come From?

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Here at The Motley Fool Singapore, we often talk about how some shares have had so-and-so percentage gains over a certain number of years. But, have you ever wondered how shares can actually create value for shareholders?

Turns out, there are three easy ways shares can do that for investors:

1. Through dividends.

2. Through earnings growth.

3. Through a change in valuation multiples (such as a price to earnings ratio).

Let’s take a look at the returns of a consumer facing company that most in Singapore should be familiar with; telecommunications operator Starhub (SGX: CC3).

According to S&P Capital IQ, Starhub’s shares have returned 266% in the eight years ended 28 Nov 2013. How did those returns come about?

Dividends were a big factor in Starhub’s returns. Back them out, and the capital gains (i.e. change in share price) have been ‘only’ 127%.

The company’s earnings growth for the period was also decent, as earnings per share grew by 16% per year from S$0.067 to S$0.22. Compared to industry peers like SingTel (SGX: Z74) and M1 (SGX: B2F), whose earnings per share today had both shrank since eight years ago, it’s pretty obvious that Starhub has had a much better performance.

But now, here’s something interesting. Starhub’s earnings had grown by 228% in those eight years yet its share price only grew by 127%. Why is that so? The table below explains it:

Starhub 28/11/2005 28/11/2013
Price S$1.88 S$4.26
Trailing PE Ratio 28.2 19.5

Source: S&P Capital IQ

Starhub’s PE ratio has fallen by almost 30% in those eight years, making it difficult for its earnings growth to show up in share price returns. In such cases, it usually means that the market has become less enthusiastic about the future earnings growth of Starhub.

And, the market has good reasons for feeling lesser enthusiasm as over the past two years, Starhub’s annual growth in earnings per share has slowed to 11%.

Fortunately for shareholders, Starhub’s huge dollop of dividends – which has grown from S$0.09 per share in 2005 to S$0.20 per share in 2012 – over the years has helped make up for the contraction in the company’s PE multiple. This also shows how important dividends can be for shareholders over the long-run.

So while this has been an informative exercise (I hope!), why should investors bother about where returns come from? That’s because it can affect the way we invest and look at certain shares.

How can we find shares whose earnings growth can manifest itself adequately in share price gains? How can we avoid shares that will crash despite posting solid earnings growth? What are good ways to invest our money for maximum long-term gains?

Those are just some of the questions we can answer when we look at past examples of what has happened to real shares.

And, to answer them: 1) find shares whose business fundamentals give investors good reason to believe its earnings can grow at high rates for sustained periods of time; 2) avoid shares whose fundamentals don’t warrant a cheery appraisal of future earnings growth; and finally 3) don’t ever forget about reinvesting your dividends if you want to maximise long-term returns.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore contributor Chong Ser Jing doesn’t own shares in any companies mentioned.