How to estimate a stock’s expected return
A stock’s long-term return comes from three sources: earnings growth, the change in the multiple the market pays for those earnings (the P/E ratio) and the dividends received along the way. Breaking the return down this way turns a vague hope into assumptions you can question one by one.
The three parts
| Part | What drives it | Example |
|---|---|---|
| Earnings growth | sales, margins, reinvestment | +8.0% a year |
| Change in P/E | from 20 today to 16 at the end | −2.2% a year |
| Dividends | 40% of earnings paid out | about +2.3% a year |
| Expected return | internal rate of return of the cash flows | about 8.0% a year |
The calculator computes the exact internal rate of return (IRR) of buying today, collecting the dividends and selling at the end; the three-part sum is a close approximation that shows where the return comes from.
Compare with a safe alternative
An inflation-linked government bond pays a known real yield plus inflation, without stock-market swings. With a 2% real yield and 2.5% inflation, it pays about 4.55% a year. The difference between the stock and the bond is the equity risk premium. Investors have historically demanded about 4 to 6 points a year; much less than that means you are not paid enough for the risk.
Why the P/E matters so much
Buying at a high multiple means part of the future growth is already in the price. If the P/E falls back to a more normal level, it takes a slice of the return every year, even if the company does well. Buying at a low multiple works the other way.
Limits
- Taxes, buybacks and new share issues are not included.
- Growth and the final P/E are guesses: use the sensitivity table to see a range of outcomes.
- Real returns are not smooth; stocks can fall 30% or more along the way.