How Do Stocks Make Us Money? The 3 Engines of Total Returns

Buying shares makes us a partial-owner of a real company, and this fact gets into the heart of what investing really is. How does shareholding in a giant company like DBS translate into making real money? People tend to skimp over this detail without gaining enough understanding to invest on our own with confidence. Lets look beyond the surface ripples of daily price swings, and go slightly deeper into the the three `engines` driving total returns for us investors.

Engine 1: Earnings Growth 🌱

This is the most fundamental source of returns. When the companies you own innovate, expand, and become more efficient, their profits grow. This is earnings growth. As an owner, your shares of those profits becomes larger and more valuable. When our companies grow their earnings successfully year-over-year, its overall earnings-per-share (EPS) increases. This represents its real, underlying business value and acts as a support for its price. 

Stocks tend to trade around certain multiples of their EPS, represented by the P/E (price-to-earnings) ratio. As DBS reported a total of $4.08 EPS for FY2024, giving a current P/E ratio 11.08 at the last closing price of $45.21. 

If a bank grows its loan book and wealth management services, its revenue and earnings would rise as a result. For this very reason of being asset-based businesses, some investors prefer to look at P/B (price-to-book) ratio as a valuation metric for banks and REITs. If the P/B ratio of OCBC is below 1.0 for example, people might say that it is undervalued at the current price and it is a buying opportunity. 

Engine 2: Dividends 🍎

This engine draws power from the first engine. From the earnings a company generates, it can distribute a portion directly to you, the shareholder, as a cash dividend. This is the most direct way an investment can put money in your pocket. 

A key concept here is the payout ratio, which is the percentage of earnings a company pays out as dividends. For example, if a bank earns $1 per share and pays a dividend of $0.50, its payout ratio is 50%. 

A healthy and sustainable dividend must be supported by strong earnings. A company with growing profits can comfortably maintain or even increase its dividend over time. A moderate payout ratio (say, 40-70%) shows a good balance between rewarding shareholders and reinvesting the remaining earnings to fuel future growth. Growth stocks like the Magnificant 7 have low payout ratios and pay little-to-no dividends. 

Engine 3: The Market's Mood (Speculative Returns) 🤔

Investor sentiment plays a part in market returns. It’s measured by the change in the Price-to-Earnings (P/E) ratio—the price tag the market puts on each dollar of a company's earnings.

This price tag can change based on fear and greed.

• P/E Expansion: When investors are optimistic, they pay more for each dollar of profit, and the P/E ratio rises. This adds to your returns.

• P/E Contraction: When investors are pessimistic, the P/E ratio falls, which subtracts from your returns.

Warren Buffett famously said "to be fearful when others are greedy and to be greedy only when others are fearful". The current P/E ratio compared to an average baseline serves as a good estimate for how the market is feeling. This is key to ensure we are doing proper fundamentals analysis (FA) rather than `feelings analysis`. 

So What? A Chart To Put It All Together

Our total return is a simple sum:

Total Return = Earnings Growth + Dividend Yield + Speculative Return

History tells us that the most dependable, long-term returns come from business fundamentals of growing profits (Engine 1) and sharing profits with you in dividends (Engine 2). On the flip side, speculative returns (shown as Valuation Change above) has barely just managed to cancel itself out in the long run.

Looking at company earnings and dividends is my bread-and-butter as an investor. This is my strategy grounded in business reality, as someone who is buying a piece of multiple businesses. Are you betting on market mood swings, or planting seeds that grow and bear fruit?

Disclaimer: This blog post is for entertainment purposes only and does not constitute financial advice. Please do your own due diligence.