Despite constant attempts by analysts and the media to complicate the basics of investing, there are really only three ways a stock can create value for its shareholders:
- Dividends.
- Earnings growth.
- Changes in valuation multiples.
In this series, we drill down on one company's returns to see how each of those three has played a role over the past decade. Step on up, Johnson & Johnson (NYSE: JNJ ) .
J&J shares returned 39% over the past decade. How'd they get there?
Dividends did most of the heavy lifting. Without dividends, shares returned just 9% over the past ten years.
Earnings growth was actually quite good over the period. J&J's earnings per share grew at an average rate of 7.9% a year for the past ten years. That's about as much as you should expect a megacap company like J&J to produce in the long run.
But if earnings growth was so strong, why were shareholder returns so low? This chart explains it:
Source: S&P Capital IQ.
Like so many other companies, J&J's valuation multiple has fallen hard over the past decade. That's prevented the success of earnings growth from being reflected in shareholder returns. The impact this has at companies like Wal-Mart (NYSE: WMT ) and WellPoint (NYSE: WLP ) has actually been worse -- both have undergone periods when earnings doubled while shares went nowhere.
J&J shares are much more reasonably valued today than they were ten years ago, so shareholders are unlikely to experience the same going forward. The returns do, however, highlight one of the most important lessons in investing: Future returns are determined by starting valuation. Shareholders sealed their fate by buying shares at over 35 times earnings ten years ago. Those buying shares today face much better prospects.
Why is this stuff worth paying attention to? It's important to know not only how much a stock has returned, but where those returns came from. Sometimes earnings grow, but the market isn't willing to pay as much for those earnings. Sometimes earnings fall, but the market bids shares higher anyway. Sometimes both earnings and earnings multiples stay flat, but a company generates returns through dividends. Sometimes everything works together, and returns surge. Sometimes nothing works and they crash. All tell a different story about the state of a company. Not knowing why something happened can be just as dangerous as not knowing that something happened at all.
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