Bonds are considered safe because they have fixed payments. Stocks, on the other hand, have earnings that can vary from year to year and are therefore considered riskier. Although many stocks pay a dividend, a large part of a stock's return comes from its earnings. This makes it difficult to judge how much return an investor can expect over the years. However, some stocks are so reliable that their return can be counted on much like that of a bond payment. What follows is a method to determine this "payment."
Future share price
Wells Fargo & Co. (NYSE:WFC), for instance, has delivered average annual revenue growth of 10% over the past decade and earnings growth of 6.24% over the same time period. This stock is also one of Warren Buffett's favorite long-term holdings. Given the company's consistent operating history and Buffett's stamp of approval, it appears to be a reliable stock.
In order to determine Wells Fargo's "payment," we must first determine what the company's future earnings will look like. One way to do this is by looking at the company's equity and return on equity. Equity is simply everything the company owns minus everything it owes. Return on equity can be thought of as the amount of profit generated for each dollar of equity in the company. If we can figure out the future value of Wells Fargo's equity, then we can use return on equity to figure out its future earnings and selling price.
For Wells Fargo, the equity value per share is $37.04. Management has been able to grow this value by an average rate of 8.14% over the past decade. This growth is not the same as return on equity as it represents how much Wells Fargo equity has increased over the years, not how much profit has been generated from it. If this growth continues, then the future per-share equity value for Wells Fargo will be $81 in 10 years.
Also, the company has generated a return on equity average of 12.7% over the same time period. If these returns continue, then the company will be earning $10.28 per share in the future. This was found by multiplying the future per share equity value by the company's average return on equity. Since the company has been consistent in its earnings performance, we can assign a high degree of confidence to this projection.
Now, how much will others be willing to pay for these earnings? To answer this question we turn to the company's earnings multiple. The earnings multiple simply tells us how much investors are willing to pay for each dollar of earnings. For Wells Fargo, investors were willing to pay $10 for every dollar of earnings in 2011. This is the lowest earnings multiple for the company over the last decade and provides a worst-case scenario for our projection. If we multiply this number by the estimated future earnings of $10.28 we find that Wells Fargo stock could be trading for $102.83 per share in the future.
With Wells Fargo currently trading at $50 per share, the stock price will have to grow at an average rate of 7.5% per year in order to reach the estimated future value. If the assumptions used in this model come true, then this is the "payment" or rate of return that investors can expect.
Is this good? To answer this question we look to the rate of return we can get without taking any risk. This would be the rate on long-term U.S. treasury bonds which are considered safe because they are backed by the U.S. government. The current rate on these bonds is right around 2%. With a return of 7.5% Wells Fargo is the better investment.
In the final analysis, Wells Fargo is a reliable company with a projected "payment" that is superior to that of the risk free rate. Keep in mind two things though: First, projections are like the knobs on the Hubble space telescope -- adjust them but a little and you are looking at an entirely different universe. Second, it might be possible to find stocks with returns that are juicer than Wells Fargo's using this model. If the company has a consistent operating history, then more confidence can be placed in the projection.
Adam Brownlee owns shares of Wells Fargo. The Motley Fool owns shares of and recommends Wells Fargo. The Motley Fool has the following options: short May 2016 $52 puts on Wells Fargo. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.