Despite constant attempts by analysts and the media to complicate the basics of investing, there are only three ways a stock can create value for 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, Cisco
Cisco shares returned a total of negative 5% over the last decade. How'd they get there?
The company only recently started paying a dividend, so that wasn't much of a factor. Without dividends, Cisco shares lost 6% over the last 10 years.
Earnings growth was incredibly strong. Cisco's normalized earnings per share grew at an average rate of 17.8% per year from 2001 until today. That's substantially above the market average, and impressive given the company's enormous size. There's no doubt about it: In terms of earnings, the past decade has been a successful one for Cisco.
But if earnings were so strong, why were returns so low? This chart explains it:
Source: S&P Capital IQ.
Cisco shares were a complete and utter bubble 10 years ago. That's prevented all of the company's earnings growth over the last decade from turning into shareholder returns. The same has been true for other large-cap tech stocks like Microsoft
It's hard to exaggerate how overvalued Cisco was 10 years ago. As Princeton professor Burton Malkiel noted, with a market cap of $600 billion and a P/E ratio well over 100, "[I]f Cisco returned 15 percent per year for the next twenty-five years and the national economy continued to grow at 6 percent over the same period, Cisco would have been bigger than the entire economy." Those expectations were, of course, absurd, and so shareholders ever since have gotten what they deserve: zero returns amid otherwise solid earnings growth. This should drive home one of the most important lessons in investing: Starting valuations determine future returns.
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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