According to finance theory there are three components to the total return which an investor can make from a share.
Firstly, we have dividends. Often being the most modest source of equity returns, dividends can nevertheless be consistent and provide a useful source of income for investors. Those with shares in dividend paying FTSE 100 companies, for example, are currently enjoying average yields of c.3.8%, within a range of 0.24% to 7.9%. Over and above these “normal” dividends is the sought after special dividend, paid by companies which generate significant amounts of excess cash or those which earn a bonus from an extraordinary event such as an asset sale or legal victory. Of course, dividends can never be negative.
The second component to equity returns is changes in the price/earnings (PE) ratio which a share trades on over time. Say a company makes 10p of annual earnings and trades on a PE ratio of 10 times, then its price will be 100p. If earnings remain the same but the PE ratio changes to 12 times, then the shares will be trading at 120p, a gain of 20%. On the other hand if the PE ratio changes to 8 times the shares will be priced at 80p – a loss of 20%.
Changes in the PE ratio can be an important source of returns, especially for those who take the “value” approach to investment. These investors hope to buy shares on low PE ratios and see the market re-rate them to higher levels before selling at a profit. Buying shares in times of recession, when pessimism is at its peak and valuations are their lowest, can also be a good strategy to target gains from rises in the PE multiple over time….
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