So I don’t generally watch my share prices go up or go down (I don’t always get this right though… we are all humans with emotions after all). My friends often let me know that you cannot measure how your investments have done if you ignore performance. Ah but I counter you need to understand the sources of an investment return to free yourself from watching the ticker tape of stock prices go round and round.

In 1991, John Bogle first came up with a simple equation for the components of investment return. Some (read very few) academics have also done some work on this and produced a similar yet rather complex equation.

Please ignore the equation though as it is a far too complex one for what it actually means. The just of it is the investment returns are made up of three parts.

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Dividend yield (the money the share pays you each year in dividends) (Most important)

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The underlying earnings growth of the company

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Repricing return (the change in the PE ratio) (Least important)

Now I won’t go through the effort doing any complex maths in this post as it is unnecessary and will only complicate things. I am just going to ask you to trust me if the following does not make sense.

The simplest part is the Dividend Yield.

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I pay R100 for Company A at the beginning of the year

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At the end of the year, Company A pays me a R5 dividend

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My dividend yield is 5%

My investment return so far is thus:

Investment return = 5% + earnings growth + change in PE

Next, a company reports profits each year. This is also relatively easy to understand. For example:

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Company A increases profits by 10% this year

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My earnings growth is 10%

My investment return so far is thus:

Investment return = 5% + 10% + change in PE

The last component is the most difficult to explain. Luckily, it is the part the matters the least. Unfortunately, a lot people obsess about PE ratios. The research I have seen is that the return generated from this last factor accounts for the least amount of total return. Some studies have even shown it to be close to zero percent in most markets (See Arnott and Bogle’s books).

Here goes a explanation. Stocks trade on PE multiples (or ratios). For example, say a company earns R1 a year and its share price is R10. It will have a PE ratio of 10. I.e. Share Price divided by earnings equals 10.0. PE ratios tend to change in the short depending on the mood in the market and it often seen as speculative in nature.

If this ratio increases to 10.3 and the company still earns R1, it means that the price must have increased. This change in the P/E ratio is the last component of return. The change here is 3%.

My investment return so far is thus:

Investment return = 5% + 10% + 3%

The total investment return is 18%.

So why should you care? The point is that you should worry about the two components of return you have some modicum of control over. You can construct a diversified portfolio of companies which pay a healthy dividend and are able to grow their earnings on average a little bit ahead of inflation every year. The information is readily available. Forget about PE ratios. Forecasting whether company is going to trade on a 10 or 11 PE at year end is a mug’s game. If you follow this conservative and disciplined investment approach you are setting yourself up for a better than average investment return over the long term.

*The above is a simple depiction of the

Grinold and Kroner equation. This has purposely been done. For those interested in finding out more, please see

here.

*This is not financial advice either. Always consult a financial advisor (one that is decently priced though) before making any financial decisions.