A term deposit tells you exactly what you will earn. The bank quotes a rate, you commit your money for a set period, and the arithmetic is finished before you begin. A share offers no such promise, yet that does not leave the expected return a mystery. Whatever you own through the share market, your return comes from just three sources: how quickly the business grows, how much it pays you while you wait, and whether the market’s mood towards it improves or sours. Estimate each honestly and you can put a sensible range around what a share might deliver over the next five years at today’s price.

Growth: is the business getting bigger or smaller?

The first question is whether the business is becoming more valuable. Earnings per share over the past five to ten years is the simplest measure, because over time a share price tends to follow the profits behind it. A business growing earnings at 4.5 per cent a year will be roughly a quarter more valuable after five years. One that is shrinking will usually see its share price drift lower.

Care is needed with the window you choose. A single exceptional year, such as a one-off asset sale or a pandemic windfall, can make a healthy business look as though it is going backwards. Looking at the most recent five years, or at the years after the unusual one, often gives a fairer picture. A short history, say six years rather than ten, deserves less trust, and it is reasonable to demand a higher return before relying on it.

The discipline is to use what can be seen. Management forecasts and exciting stories may prove right, but a prudent estimate starts from what the business has actually done.

Dividends: what does the business pay you to wait?

The second source is the income you collect along the way. A quick shortcut works well. Divide 100 by the price-to-earnings (P/E) ratio to get the earnings yield, which is the share of the price the business earns each year. A P/E of 31 gives an earnings yield of about 3.2 per cent. If most of that is paid out as fully franked dividends, the yield including franking credits is in the order of 3.5 per cent.

The payout ratio matters because it tells you how much of the earnings reaches you rather than staying in the business. A company on a P/E of 72 earns only about 1.4 per cent of its price each year, and paying out two-thirds of that leaves a cash yield under one per cent, or a little over one per cent once franking is counted. Franking also depends on where a company is based, and foreign companies often deliver less benefit than Australian ones. None of this needs precision. It needs a sensible ballpark.

Sentiment: the driver most investors forget

The third source is the one that trips up most people, because it never appears in a company’s own accounts. The P/E ratio is the price the market is currently prepared to pay for each dollar of earnings, and it swings with mood. Compare today’s P/E with its range over the past ten years. If it sits near the top of that range, the odds favour it drifting lower, which will subtract from your return even while the business does well. If it sits near the bottom, sentiment is more likely to help than hurt.

The arithmetic can be sobering. Take a business growing earnings at 15 per cent a year. Over five years its earnings would roughly double. If its P/E is 72 today and falls to 36, which is still around the middle of its historical range, the share price ends up roughly where it started and the whole of the growth has been absorbed. The dividends are all that is left. The business performed superbly and the investor earned little more than a modest income. The same logic works in reverse for a solid business trading near the low end of its range, where the three sources can reinforce one another rather than cancel out.

From estimate to decision

Add the three pieces together and you have an approximate annual return: growth plus dividends, adjusted up or down for sentiment. A business growing at 4.5 per cent with a 3.5 per cent yield, on a P/E near the top of its range, might land somewhere around 6.5 to 7 per cent a year once a little sentiment drag is allowed for. Whether that is attractive depends on the alternatives, whether a term deposit, another business you understand equally well, or simply waiting.

Here the most useful idea is that “not at this price” does not mean “never”. A P/E that is high today has usually been lower at some stage in the past decade, so a business can sit on a watch list with a price trigger in mind. Opportunities that combine low sentiment, a healthy dividend and real growth are uncommon, perhaps only a few in a month, so finding one after an hour or two of work is a good result. The estimate also leaves out judgement that numbers cannot supply, such as regulation, competitive position and where the industry sits in its cycle. The sum starts the thinking. It does not finish it.

Quality tells you what to own, but price decides what it is likely to earn you. A superb business bought at an exuberant price can deliver an ordinary result, and an unglamorous one bought at a depressed price can surprise. Running the three-part sum before committing money replaces hope with a reasoned range, and it supplies the patience to wait, because sentiment, unlike the quality of a business, rarely stays extreme for long.

Teaminvest Takeaway

At Teaminvest, we treat price as part of quality. A great business only becomes a great investment when the price paid leaves room for the return to compound, and Conscious Investors® use the market’s mood swings to their advantage rather than being pushed around by them. Volatility is a friend here, because it is what eventually brings quality companies back to prices that make sense. We research slowly, move quickly only when price meets value, and remember that a good company missed at a fair price tends to return to one within 12 to 18 months.

General information and education only. Nothing here is personal financial advice or a recommendation to buy, sell or hold any financial product. Teaminvest Pty Ltd, part of TIP Group, AFSL 334339.

This topic was covered in Episode 38 of Wealthy + Wise on the Teaminvest Wealth Builders channel. Watch the full episode on YouTube or listen via Buzzsprout