A Brief History of Reynolds American's Returns

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:

1. Dividends.
2. Earnings growth.
3. 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, Reynolds American (NYSE: RAI).

Reynolds' shares returned 405% over the past decade. How'd they get there?

Dividends did the heavy lifting. Without dividends, shares returned 168% over the past 10 years.

Earnings growth was decent. Reynolds' normalized earnings per share grew at an average rate of 6.4% over the past decade. That's nothing to write home about, but it's respectable given the decline in smoking rates.

But that brings up an interesting dynamic that you almost never see these days. If earnings growth was meager, why were returns so high? This chart explains it:

Source: S&P Capital IQ.

The vast majority of large-cap stocks were overvalued 10 years ago. That's kept their returns low even as earnings growth has been strong. Reynolds is the other way around. Shares were undervalued 10 years ago -- likely kept low by constant litigation worries -- and so shareholder returns have since surpassed earnings growth as valuation multiples expanded. The same has been true for rival Altria (NYSE: MO), but very few other companies can tell a similar story.

If there's one lesson investors should remember from the past decade, it's that starting valuations determine future returns. Buy cheap, and even subpar earnings growth can deliver high returns. Pay a dear price, and even high earnings growth can leave shareholders stranded. Reynolds' phenomenal returns amid bland earnings growth is one of the best examples of that you can find.

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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