You can’t predict the future, so why do investors try?

12th January 2012

The total return made on any equity investment can only come from three sources:

  1. from a company's dividends
  2. from a change in its share price, which stems from a change in its earnings per share (EPS)
  3. from a change in its share price, which stems from a change in the valuation multiple.

Thus, if you make money from the equity market , you will only have done so in three ways – EPS change, multiple change and/or dividends. That is it.

Of the three, dividends are – relatively – easier to predict and, as they are less volatile than profits, can be a solid source of return in uncertain times. Nevertheless, a company should not pay out all of its profits in the form of a dividend otherwise it would have nothing left to reinvest in order to grow its profits and, consequently, its share price.

Turning to the other two factors, over the long term, the change in the overall market's multiple has to be a constant – in other words, it does not impact on total returns – while EPS growth is bound by growth in the broader economy. As such, over time, real returns for the stockmarket as a whole broadly come down to GDP growth plus dividends.

In the short run and at a stock level, however, it is a different story because it is possible to have companies that grow faster than the economy for a while and multiples that change over time. The trouble is, predicting which companies will grow faster than average is extremely difficult – indeed, statistically, only one company in the FTSE All Share index will achieve that on a consistent basis over the coming 10 years – do you want to predict which one?

Nevertheless, predicting earnings growth has become the goal for many investors who, buoyed by their spreadsheets and corporate histories, feel confident in their ability to predict the future for a stock's profits to however many decimal places. Unfortunately, history would suggest that, for the great majority, such confidence is misplaced.

Read more…

 

More from Mindful Money:

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A value investor’s guide to 2012

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