Analysis To Understand Equity Returns

Analysis to Understand Equity Returns is one of the very important analysis based on methodology that will help you to understand it better when making your allocation decisions in equity.

Equity Returns over a period always have three sources or constituents that makes it. If you understand equity returns then you will have a little idea to sense when to own SENSEX and when to not. 😉 

Three Sources of Equity Returns

The Total Returns in Equity have three sources – Fundamental Returns, Speculative Returns & Dividend Yield.

1. Fundamental Return: This is the base source of equity returns because over the long run price of equity follows the fundamentals.
2. Speculative Return: This source of equity returns arises out of sentiments, behavior or trend of market participants towards the market.
3. Dividend Yield: This part of equity return is given directly to investors from the profits of companies.

Fundamental Return consists the earning behind the business along with the dividend paid out to investors during the holding period. Whereas, Speculative Return can be calculated by earnings multiplied by change in PE ratio divided by the price paid.

Hypothetical Study

Let’s Understand these returns more clearly with an example of ABC Ltd. whose Earnings Per Share (EPS) is Rs.10 and is currently quoting at PE of 20 which results the stock price at Rs.200.

Now, at the end of the year the Earning of ABC Ltd grew by 20%

There will be three different scenarios:

1. Stable PE Ratio: As Earnings grew by 20% the EPS at end of year will now be Rs.12 and in the scenario of Stable PE Ratio the PE remains 20 which will result in stock price of Rs.240, resulting Total Returns of 20% which consists of only fundamental returns.
   

   Fundamental Return	20%
   Speculative Return	0%
   Total Return	20%

2. PE Ratio Expansion: As Earnings grew by 20% the EPS at end of year will now be Rs.12 and in the scenario of PE Ratio Expansion the PE increases to 25 which will result in stock price of Rs.300, resulting Total Returns of 50% which consists of fundamental returns of 20% and speculative returns of 30%
   

   Fundamental Return	20%
   Speculative Return	30%
   Total Return	50%

3. PE Ratio Contraction: As Earnings grew by 20% the EPS at end of year will now be Rs.12 and in the scenario of PE Ratio Contraction the PE decreases to 15 which will result in stock price of Rs.180, resulting Total Returns of -10% which consists of fundamental returns of 20% and speculative returns of -30%
   

   Fundamental Return	20%
   Speculative Return	-30%
   Total Return	-10%

The speculative returns in both the cases of PE Expansion and PE Contractions are calculated by multiplying earning with the change in PE ratio and divided by Price Paid.

In above example of PE Expansion,

EPS x (Change In PE Ratio) / Price Paid

12 x 5 / 200

60/ 200 = 30%

This overall analysis of ABC Ltd in all three scenarios will help you to understand equity returns and how it consists of both speculative and fundamental returns.

Conclusion

Always try to figure out businesses you are looking to invest in or invested in using above analysis of equity returns to get an idea of fundamentally strong businesses. It will help you to know when there are speculative returns so that you can be cautious with your positions in those businesses.

Remember, In long run price follows the fundamentals.

This analysis works the same way in the broad market indices like SENSEX or NIFTY if you are looking to do analysis of market at broad level you can analyse them like this.

References

1. Value Investing & Behavioral Finance by Mr. Parag Parikh