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SECTION 5 OF THE SSG: 5-YEAR POTENTIAL
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5 5-YEAR
POTENTIAL
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GENERAL INFORMATION
This section calculates the current and potential dividend yield and the potential return on your investment. It shows the percent annual return the stock will produce if all of the estimates from Sections 1-4 are reasonable and actually develop. In essence, it shows you if your estimates and projections will enable the stock to double its value in the coming five years.
SECTION 5-A: PRESENT YIELD ON THE PURCHASE PRICE
To calculate, divide the current yearly dividend by the current price and convert to a percentage. This is a measure of the cash return you are making on your investment at today's stock price.
SECTION 5-B: AVERAGE YIELD OVER NEXT FIVE YEARS
Ideally a growing company should increase its dividend each year as its earnings grow. If dividends do not increase, it is important to check the 10Q and 10K reports to determine why they are not increasing. For example, in times of economic slow-down, dividends may be cut. Other companies simply prefer to keep dividend payout low and instead use that money for such things as research and development (R&D) and expanding their operations. In fact, some companies prefer not to pay a dividend at all.
The average dividend per year expected over the next five years is determined by following the earnings-per-share trend line to the mid-year line for the future five-year period (Side 1 of the SSG). This is then multiplied by the percent payout in dividends (Section 3, Column G, line 8).
PERCENT PAYOUT:
The average percent payout (Section 5, line B) is taken from Section 3, column G, line 8. Line 8 shows the percent of earnings paid out in dividends. Some companies pay dividends while others do not. The percent payout number/value will affect all other calculations in Section 5; thus, it is important that you make any changes you believe important to the percent payout in Section 3, column G, line 8. You can eliminate any of the values in Section 3, column G, that you believe are unusual. For example, the percent payout may have been increasing and then started to decrease. You may opt to eliminate the highest number before it started to decline. This will lower your average percent payout (column G, line 7) and provide a more reasonable number to plug into Section 5-B. A more reasonable number in Section 5-B will mean a more reasonable Average Total Annual Return Over the Next Five Years (Section 5-C).
The percent of earnings paid out in the future five years may increase or decrease from the historical five years for a number of reasons. For example, the company adopts a new dividend policy or the company is maturing and can pay more of its earnings in dividends. You can gather some of this information from the 10K report (annual report) or annual report. If, given the information in these reports, you predict the earnings paid out in the future will differ from the past, it is important that you readjust the figure in column G, line 7, to be in line with what the company is projecting.
In general,
a. if dividends are increasing while payout is decreasing, then investors are
getting more and the company is keeping more.
b. if dividends are increasing but payout is increasing, investors are getting
more but the company is keeping less-may be a red flag.
c. if dividends are decreasing and payout is increasing, then it is definitely a
red flag. More investigation is needed.
To do the calculation for 5-B, the average earnings per share for the next five years is multiplied by the average percent payout. This figure is then divided by the current price to determine the stock's average dividend return over the next five years.
GUIDELINES FOR JUDGMENT
OUTLIERS:
Examine the history of the percent payout (Section 3, column G) for the past five years. Delete values in past years that reflect exorbitant payouts. Deleting outliers will create a more realistic average percent payout that can then be used to predict average yield over next five years (Section 5-B).
SECTION 5-C: ESTIMATED AVERAGE ANNUAL RETURN OVER NEXT FIVE YEARS
The estimated annual return over the next five years is divided into three areas: Average total annual return over the next five years, percent compounded annual rate of return based on Projected Average Return (P.A.R.), and percent compounded annual rate of return based on Total Return.
Average Estimated Annual Return Over the Next Five Years
This calculation takes the gross percent appreciation of your investment over the next five years and divides that figure by five. Then the estimated average yield (5B) is added to that figure. This is known as the simple annual rate of return.
A figure of 20% is required to double your money in the next five years. Twenty percent is required because the calculation is based on your original investment and does not take into consideration any money earned on the growth of that investment over five years.
P.A.R. (Projected Average Return)
This is the return on your investment when you purchase the stock at today's price and sell it in five years at an average price. The price is calculated by multiplying the high EPS (Section 4B) by the average P/E (Section 3 line 8) rather than the average high P/E. The P.A.R. is a more modest figure and a more realistic expectation.
A figure of 15% is required to double your money in five years.
Total Return
This is the annual return from both the investment's price appreciation and dividend yield. It is known as the compounded annual rate of return.
A figure of 15% is required to double your money in five years.
Note: NOT every stock has to produce a 15% return. The average return of the stocks in your entire portfolio should be at least 15%. Larger, more mature companies will give a lower return on investment (e.g., 7%-10%) because their growth rates have slowed. Balance stocks with a lower return on investment with stocks having a return in excess of 20%.
Sources:
1. NAIC Investor's School Instructor's Script, "What's Total Return All
About," Ellis Traub, Oct. 8, 2001.
www.better-investing.org/chats/transcriptlist.html. Scroll down the page and
click on the title "Advanced Topic--Total Return."
2. "SSG: The Back Side," Hugh McManus, NAIC Congress, Philadelphia,
August 2000.
3. Investors Toolkit, 3rd and 4th editions, Inve$tWare Corporation.