How Is Total Return Used to Price Stocks?
Total return is the combination of capital gains from the purchase and sale of stocks and any stock or cash dividends received during the period the stocks were held. Total return is very dependent on the length of time a stock is held. Day trading relies heavily on short term capital gains movements and not dividends. Long term investors enjoy a substantial portion of total return from dividends.
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Total Return Used for Estimating Earnings
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Company stock prices generally follow the trend of earnings. Small companies with sharply rising profits usually imply that the marketplace for their products is growing rapidly. Investors know that because of the rapid growth a generous dividend policy is not feasible. The company needs cash to continue to expand their market, avoid debt, and thus boost stock price. Hence, stock price is usually correlated with just earnings and not dividends for small companies.
Mid Size Companies
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Earnings in mid-size companies implies steady growth, not the rapid growth of the small company build-up. A dividend policy may now be in place and expectations are that dividends with generally accompany an expected steadily rising profit picture. Thus the total return of the company is one where more of the company growth can be realized immediately through dividends. The safety of the total return is therefore improved though at the cost of a slowing profit outlook.
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Large Capitalization Companies
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Large capitalization companies command worldwide attention for their products. Growth is dependent upon the brand loyalty to the many thousands of products already marketed. New profit growth comes from corporate acquisitions. Dividends become a much larger part of total return and tend to follow the rate of growth of the company. The ability to pay dividends in good and bad times is exceptionally strong based on the consistent cash flow of the company. Total return is heavily based on the security of consistent growth and dividends.
Comparative Returns
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Stocks in the same industry tend to trend the same way. There is a high correlation among industry related stocks to their performance. Separating the best performing stocks in the same industry is generally the ability to create capital gains. Capital gains is the driver of total performance, not dividend policy, in determining stock price among companies in the same industry.
Total Return is Not Profits
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Investors must understand the difference between reported earnings and actual earnings. Different industries use different accounting rules for recognizing revenue and expenses. Consequently, institutional investors tend to focus on the rate of cash flow, or how fast cash is available for new investment and dividends. This is really another way of looking at the total return possibilities of a company. It is more efficient than estimating earnings which can be affected by accounting and bookkeeping issues.
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