How to determine return on investment when trading in shares

Often times, potential investors leave it to financial analysts and other professionals to decide for them where to put their money or to help them interpret financial information on an organisation.

But what if a potential investor decides to go it alone? What informs his/her decision?

Obviously one relies almost entirely on financial reports from the company itself or from financial markets.

Because of insufficient information, sometimes investors may exhibit a herd mentality – wanting to invest where most people are going, without knowing exactly why a section of the market is behaving in a particular manner.

A few years ago, investors were driven to oversubscribe shares of a company during a public offering, primarily influenced by an earlier success in such undertaking, oblivious of the fact that at any point in time, companies present different financial and business scenarios.

It is important for an investor to know the basic measurements of a company’s performance. Some important details may not be readily available to an ordinary investor unless further analysis is done.

For instance, earnings per share ( that is income available for distribution to the owners of business after making provision for tax expense) though a useful tool, may not be sufficient for comparison purposes when considering two companies whose share prices are not the same.

Consider company A whose shares are trading at Sh300 per unit and with earnings per share of Sh30 and company B whose shares are trading at Sh200 and with earnings per share of Sh25.

From the onset, it appears that company A is doing better. Further analysis indicates otherwise.

Theoretically, if you were to invest in company A , you will spend Sh300 and expect a return of Sh30, hence an earnings yield of 10 per cent. With the same arithmetic, company B will promise a return of 12.5 per cent.

How about growth in respective companies? Company A’s shares are trading at Sh300 while B is trading at Sh200.

If two years ago company A shares were trading at Sh220 and and B’s at Sh180, and an investor decided to buy shares in both companies, it is worthwhile to find out which of the two investments have yielded higher returns over the two years.

From Sh220 to Sh300, company A shares have increased in value by about 36 per cent while company B has appreciated by 11 per cent. In this respect, A has had better performance over the two years.

Which stock will a potential investor pick in this case? We enter the concept of dividends.

Many established companies, subject to availability of cash and future commitments, pay dividends twice. The first is called an interim dividend, which is paid long before the company’s year-end.

The last one is paid at the end of financial year and after the financial statements have been approved by board of directors.

A savvy and knowledgeable investor will care more about dividends and share price appreciation than earnings per share. Why so? These give reasonable estimation of returns over a period of time. Back to the example above.

Assuming simplistically that company A paid dividends of Sh15 during the past year and Sh20 in the year just ended, the two payments sum up to Sh35. Over the two years the market price of the shares has appreciated to Sh300 from Sh220, or by Sh80.

The total return over the two years is Sh115 (52 per cent over two years or 26 per cent per year on average), made of dividends received (Sh35) and share price appreciation (Sh80).

What if company B paid a Sh20 in the previous year and also Sh20 in the year just ended? With share price appreciation of Sh20 and total dividends of Sh40 for the two years, the return is 33 per cent.

Dividends carry more weight because it is cash in the pocket. Share price appreciation is a good indicator of a good stock but just as important if shares are finally sold and cash received (less applicable taxes).

Mr Were is a consultant with Anchorage, a business and financial advisory firm. Email: [email protected]