Estimating annual rate of return for a stock?

Question

Hi! I'm writing a school assignment where I have to pick two stocks and estimate the annual rate of return that they will provide. The first one I picked is KCI.

I used analysts' projects from BusinessWeek (http://investing.businessweek.com/research/stocks/earnings/earnings.asp?symbol=KCI) to estimate this figure. Can you tell me if this sounds right?

"Analyst projections for the remaining two quarters of 2008 show an estimated increase of $1.84 per share, and the total annual earnings for 2009 are estimated at $4.08 (6). The total earnings for the investment over the period June 2008 – June 2009 can therefore be estimated at $3.88 per share (1.84+4.08/2). On June 24, 2008, the price per share for KCI stock closed at $38.52. This yields a rate of return of 10.07%."

Does that make sense? Or is there a better way to estimate the annual rate of return for a stock? Thank you!

Answer 1

there are different ways to do it, and the answer kind of depends on why you are asking. is it for college homework? for your own personal investing.

Expected rates of returns can be calculated many ways, with the most common being various forms of the Capital ASset Pricing Model. I'll get back to the CAPM in a second.

First though, your expected RoR is = Capital Gains + Dividends, so the formula would be

(CapGains + Dividends) / Beginning Stock Price

this logic is what you're seeing in the quote above.

But CAPM is widely used in the 'real world', although there are many different variations, and there is alot of controvsey ou there re so many aspects. but to keep things simple, if I was to calculate a company's expected return for the next year, the formula would be:

Rf + Beta(1 Yr. ERP) + Alpha

Rf = risk free rate, in this case the one year tbill yield

Beta = one year beta of your company's stock

ERP = Equity Risk Premium, which is generally calculated on a long-term basis. check Ibbotson for this kind of info, or justify an ERP using logic. you can also justify your expected cap gains in the first formula using logic and empirical data

Alpha = is teh critical part, b/c that is the additional risk/return characteristics specific to the company you're analyzing.

so, the more risky the ocmpany, the higher the alpha. so in this example, say the numbers work out to be:

4% + 1.1(5) + Alpha;

= 9.5% + Alpha.

Say that your company has a poor management team. an unhealthy balance sheet, and declining sales and margins. your alpha might be very high. say 5.5%, for a total expected one year return of 15%.

or say your company is growing like crazy, has great liquidity, manages working capital very well, etc etc. maybe their alpha is negative 1.

so 8.5% is your expected return. implying it's less risky. the higher the risk, the higher your alpha.

this is a simple example. and you can also reconcile the various caluclations you get.

also, ibbotson's cost of capital provides all kinds of premia, such as size premia (small companies are more risky), industry premia, etc. . that's in the ibottson SBBI book.

the ibottson Cost of Capital Yearbook also has good info by industry.

Answer 2

EPS is based off accounting earnings and is not a cash flow received by investors.  Returns from a stock come in two forms: Dividends and capital gains.

You can easily find what dividends a company usually pays out by using www.wsj.com or google finance.

Capital gains is the change in stock price over the holding period...this can be positve if the stock price goes up, or negative if the stock price goes down.

Forecasting a stocks future price is a VERY VERY complicated task and if anyone could accuartely predict it theyd be a trillionaire. One method is to use a discounted cash flow model...this entails a lot of work and analysts on wall street make big bucks knowing how to do it.  For the purpose of your assignment you can use google finance to find the average price analysts expect the stock to be.  Then to find the rate of return you would take the capital gain(future price- starting price) add dividends and divide that by the starting price;

Example: ABC corp

Starting price $10.00

Quarterly dividend: $0.10

So yearly cash from dividend = (0.10*4)= $0.40

And say analysts expect the stock to trade at $12.00 in one year.

The rate of return equals (2.00+.4)/10 =24 percent

Answer 3

An easy way to do it is to use the Earnings Yield.  Next year's estimated earnings divided by the current price.  This is the opposite of the P/E ratio.  From the earnings yield you subtract the yield on the ten year treasury note.  The result is called the equity risk premium.  The higher the risk premium the higher the expected return.