What Is a Fair Return on Equity Investments?
Original post by Leslie McClintock of Demand Media
There is no single definition for what constitutes a "fair return" for equity investments. That figure would be different from security to security and from investor to investor. An acceptable return would be a return that matches or exceeds the expected returns available from alternative investment or savings opportunities with comparable amounts of risk, and one which compensates you, the investor, for the risks you are taking with your capital.
Risk-Free Rate of Return
Many investment analysts start with the risk-free rate of return as the floor of acceptable levels of expected return from any given investment. The risk-free rate of return, or RFRR, is the interest rate available by investing in risk-free or extremely low-risk savings vehicles, such as bank CDs, money markets and fixed annuities. Any equity investment should exceed the risk-free rate of return. If it doesn't, there's no reason an investor should take any risk at all for the prospect of a return inferior to those available with no market risk.
Equity investments carry substantial risks. The company can be doing fine, internally, but the entire market could fall, carrying the company stock prices with it through no fault of the company's management. Or misfortune could befall another company in the same industry, causing stock prices to fall throughout the industry, again through no fault of the company. Or the company itself could fall out of favor, or undergo difficulties, causing the stock price to fall. In the worst case, the the stock could even become worthless through bankruptcy or if the ceases operations. Stocks should be priced to have enough potential upside to compensate the investor for the risk of losing some or all of his investment.
Price to Earnings Ratio
The price to earnings ratio, or P/E ratio, helps the investor identify how much it costs to "own" a dollar per share of earnings from the company. The P/E ratio is simply the current share price divided by the amount of earnings per share in the most recent year posted. For example, a stock with a share price of $10 and which posted $1 per share of earnings has a P/E of 10. You can compare this number to other stocks in the same industry or with similar risk characteristics to help you arrive at a reasonable price you should be we willing to pay. Some analysts devise a forward P/E by estimating the next years' earnings numbers, which may be helpful if the company's fortunes are changing very rapidly. Remember that some companies do not post consistent earnings and some companies have no profits at all. In these cases, the P/E would be of little or no value.
If the stock issues a dividend, compare this dividend with other comparable investments. Understand, however, that dividends are taxable, unless the stock is held in a tax-advantaged account. If you have a relatively high dividend and your analysis of the company indicates that this dividend is likely to remain stable, then the stock is a potential candidate for your portfolio. You will receive future dividends, if any, and ultimately should potentially benefit from the growth of the company -- even if the company only grows in line with the population or the economy at large. If the earnings are sufficient and consistent enough to support the dividend payments going forward, this may well portend a fair return on your investment -- provided you are in a position to tolerate the risks that come with any equity investment.
- New York University: The Risk-Free Rate of Return; Aswath Damodaran; December 2008
- Finplan.com: Dividend Growth Model
About the Author
Leslie McClintock has been writing professionally since 2001. She has been published in "Wealth and Retirement Planner," "Senior Market Advisor," "The Annuity Selling Guide," and many other outlets. A licensed life and health insurance agent, McClintock holds a B.A. from the University of Southern California.