What Drives Stock Return

How does a stock generate return for investors? There are lots of ways to break it down, but in this article I will focus on one of the simplest breakdowns. I will borrow the Grinold-Kroner Model. 

You buy a stock of a company from the exchange. You have a finite time horizon, after which you want to sell the stock in the exchange. During your holding period the price may fluctuate a lot. What matters is at what price you buy and what price you sell. In between these two points, you will receive some dividends if the company disburses some of its cash flow to the stockholders. 

Now you understand, you can make money in two ways from a stock. The price appreciation, if the selling price is higher than the purchase price, and the dividend that you receive during your holding period. 

Dividend: A company that generates handsome cash flows and don’t have much option to reinvest that cash, will most likely share the cash flow with the stockholders either in the form of dividend or buybacks. In Bangladesh, buybacks is not available. So, there is only dividend. 

Earnings Growth and Change in Multiple: We can break down the price appreciation/depreciation into two parts: earnings growth and change in p/e multiple. Price appreciation happens if you buy a stock whose earnings growth goes up from the point you buy it and the multiple either remains the same or expands. 

For example, stock A is currently trading at BDT 20 and its recent 12 months EPS (earnings per shre) is 2. The market is pricing the stock at 10x p/e which means investors are currently willing to pay BDT 10 for BDT 1 EPS. Next year, if the EPS goes up to BDT 3 and p/e multiple remains the same, the stock should be trading at BDT 30. Here, the whole price appreciation of the stock is due to earnings growth. Along with the earnings growth, if p/e multiple expands to 10x to 15x, price should go up to BDT 45. Here, the price appreciation is driven by both earnings growth and multiple expansion. You can think of other way around where the combination of negative earnings growth and multiple contraction can cause the stock price to dip. 

Here is an example of a particular stock in Bangladesh, here Grameenphone (DSE: GP; Bloomberg: GRAM BD), whose source of return in different periods, is broken down into 3 parts. 

Source: Company Financials

Above analysis shows that in both the periods, multiple expansion/contraction is the dominant factor behind the total return from the stock. Why do multiples expand or contract? We can also ask the question why investors give different multiples to the same stock at different time periods. 

Why Multiples Expand/Contract

Expectation: Every cash generating assets are priced based on expectation. When the expectation of earnings growth and/or cash flow growth is greater in the coming years, investors generally assign higher multiple. When the growth expectation erodes due to whatever headwinds, be it company specific, industry specific, or macro specific, investor assign lower multiples. A lot of the time, multiple starts contracting before earnings growth dips as the market anticipates the slowdown long before it is reflected in the numbers. 

Source: Company Financials

Liquidity and cost of fund: When there is surplus liquidity in the financial system and people or institution get access to capital at low cost, they invest more. When there is more money to invest, they pay more for the same asset. The stock market usually trades at a higher P/E during a low interest rate period. 

Flow of money: Due to a change in monetary policy, or, let’s say, some new regulation that incentivises investors to pour money into stocks, the stock market may see some new flow of money. This new money pushes up the price of the stocks of companies, even though the fundamentals remain the same as before. Hence, they start trading at a higher P/E. 

Psychological Swing: When there is optimism in the air due to positive macroeconomic or political shift, people are willing to pay more for the same asset. They see more growth and less risk in the future and such optimism is reflected in the stocks’ p/e. 

Now think of the above situations from the opposite extreme. Due to a downward revision in growth expectations, costlier money, or a shortage of liquidity in the market, a company that earns the same earnings as last year may trade at a lower price (and lower P/E) this year. 

In the case of Grammenphone, you will see there is high earnings growth and multiple expansion during 2013-17 period. The telecom giant enjoyed growth in both voice and data. Their margins expanded. They gained market share. But in the 2018-23 period things started changing. Their voice revenue growth started slowing down and ultimately hit a plateau. In data business they faced heightened price competition. And there was multiple regulatory challenges that disrupted its business. All these led to the slowdown in earnings growth and heightened risk. Average earnings growth fell to 3.8% from 10.9% in the previous period and p/e multiple fell by 9.0% as investors show concern over future growth and the risk related to regulatory issues. 

Also, the period in 2013-17 experienced more stability in the macroeconomic front. Cost of fund was relatively lower and liquidity was relatively abound. Opposite was the case in 2018-23 period when macroeconomy faced multiple challenges and liquidity continued to deplete (except second half of 2020 and first half of 2021). 

In both the periods, impact of p/e multiple expansion or contraction outweighed the impact of earnings growth. You can interpret it in two ways. Market was right in guessing that earnings growth would slowdown after the high growth period. Market also overreacted during period of accelerated growth and the subsequent slowdown. 

There is a lot of variables that go behind what multiple the market will assign to a particular stock or the overall market. The above mentioned drivers can give us some idea about the potential catalysts. Investors have to infer how much of it is reasonable and what is the extent of overreaction. If the extent of overreaction is high, there can be a potential entry point to generate handsome return.