QUALIPORT
Earnings Growth, Re-Ratings And Dividends

By Maynard Paton (TMFMayn)
December 15, 2003

Three factors dictate the total return on an individual share:

* Earnings growth;
* A valuation re-rating, and;
* Accumulated dividends.

The greater the earnings growth, the larger the (upward) re-rating and the more dividends accumulated, the better the investment result.

Earnings growth

Company earnings drive share prices: the more profits a business makes, so the more valuable it becomes. A classic example of earnings growth comes from software group Sage (LSE: SGE). If current forecasts for 2004 prove accurate, earnings per share (EPS) will have increased by a mega 944% over the past ten years:

Sage       

Year      94    95    96    97    98    99    00    01    02    03    04*
EPS(p)   0.9   1.4   1.9   2.3   2.8   4.3   5.8   6.6   7.0   8.2   9.4

(*Estimated)

And so, if the market valued the company's 1994 earnings at the same forward multiple seen today, Sage shareholders should therefore have made a 944% return on their holding since 1993.

But wait.

Re-rating

In December 1993, Sage shares traded at a spilt-adjusted 9.58p and in hindsight were valued at 10.4 times 1994 earnings. Ten years on, at 176p, the prospective price to earnings (P/E) multiple has expanded to 18.7.

So, as well as the gain relating to the expansion in earnings, long-time Sage investors have also benefited from a sizeable P/E re-rating. In this case, the P/E going from 10.4 to 18.7 has increased the earnings-based return by a massive 80%.

It all boils down to this: since 1993, Sage holders have ultimately witnessed a ten-year capital gain of 1,737%, 944% of which stemmed solely from earnings growth. The balance has been generated by the re-rating.

De-rating

Contrast the good fortune of Sage shareholders to those holding chemical group ICI (LSE: ICI) over the same ten years.

ICI       

Year      93    94    95    96    97    98    99    00    01    02    03*
EPS(p)  33.9  30.8  62.0  39.4  26.8  25.0  16.7  35.0  27.3  23.6  17.7

(*Estimated)

Since 1993, ICI's earnings have slumped 47%. Yet the shares are not down by 47% as well, but by 69%.

You see, a significant de-rating occurred at ICI, which amplified the share price loss. In December 1993, the shares traded at a rights-adjusted 641p and in hindsight were valued at 18.9 times 1993 earnings. Ten years on, at 196p, the forward P/E multiple had reduced to 11.1. The fall in P/E therefore added 22 percentage points to the 47% earnings-based capital loss.

Dividends

Now on to engine builder Rolls-Royce (LSE: RR.). Here's its ten-year EPS record:

Rolls-Royce       

Year      93    94    95    96    97    98    99    00    01    02    03*
EPS(p)   5.7   6.5   9.5  13.2  12.4  15.9  19.3  19.2  19.6  11.0  11.0

(*Estimated)

Ten years ago, Rolls-Royce shares traded at 168p. These days, they're at 174p, equating to a piddling 4% capital gain. Offsetting a 92% jump in earnings over that time has been a prospective P/E that has almost halved to 15.8. It's all meant dividends have been the only comfort for steadfast Rolls shareholders:

Rolls-Royce       

Year      93    94    95    96    97    98    99    00    01    02    03*
DPS(p)   4.9   4.9   5.0   5.3   5.9   6.6   7.3   8.0   8.2   8.2   8.2

(*Estimated)

Around 64p per share in dividends have been accumulated by Rolls investors since 1993. The income is equal to a 38% return on the 168p price seen in December 1993 and goes some way to offset the stagnant share price performance.

Shares to seek out

The progress at Sage demonstrates super long-term earnings growth can create a share price bonanza. The rewards are even greater if such growth is not anticipated and can trigger a substantial re-rating.

On the other hand, big stock market disasters like ICI occur when long-term earnings decline. Such share price falls get worse when a once generous P/E gradually de-rates to a more modest level.

And when earnings grow but the P/E contracts, as has happened at Rolls, dividends suddenly take on a much greater importance.

From all that then, long-term investors ideally should seek companies with superior profit growth potential, have the possibility of a significant P/E re-rating and which offer a generous dividend yield.

Trouble is, companies with superior profit growth potential mostly trade on racy P/Es already, which constrains the upward re-rating possibilities. Conversely, shares with low P/Es and/or generous yields tend to have restricted profit growth power and, therefore, limited re-rating promise.

Target 15%

To put the earnings growth, re-rating and dividends into perspective, targeting a 15% per annum return over ten years requires shares that:

* Produce 4% annual earnings and dividend growth, witness a P/E re-rating from 7 to 16 and possess an initial dividend yield of at least 5.7%.

Or

* Produce 7% annual earnings and dividend growth, witness a P/E re-rating from 10 to 18 and possess an initial dividend yield of at least 4.0%.

Or

* Produce 10% annual earnings and dividend growth, witness a P/E re-rating from 15 to 21 and possess an initial dividend yield of at least 2.7%.

Potential 15% per annum candidates can be posted to the Qualiport discussion board.

More: Price To Earnings Ratio | Dividend Yield