What's in an Equity Return?
How sales growth, valuation changes, and other factors explain stock returns
As the head of credit at a firm that focuses on value equities, I’ve found myself wondering what really drives equity returns. How much of it is changing valuations? How much is changing fundamentals? What about items that we believe clearly should matter but are hard to see, like changes in debt levels or the changes in share count? What is going on with Tesla?
To start tackling these questions, I broke up one-year forward equity returns into seven pieces. I am probably more keenly aware of the role of leverage in companies than most equity investors, so I wanted to separate out changes to growth in total enterprise value from changes in capital structure. What can look like growth on an income statement may be driven by faster growth of debt and share count on the balance sheet, and I wanted to see this impact directly.
The table below shows the seven components of return. I used TEV/sales as the measure of multiple change because I wanted to include companies with negative earnings, and earnings multiples do not work in that case.
Figure 1: Return Decomposition Components
Source: Verdad
Below I show the full return decomposition for Tesla as an example of how the decomposition works. The data is annual, and returns are calculated one year forward. So the 6/30/2019 line decomposes returns from 6/30/2019 to 6/30/2020.
Figure 2: Return Decomposition for Tesla
Source: Capital IQ, Verdad
Controversial details aside, Tesla acts a lot like a normal growth stock. Extremely high multiples presage high sales growth, and multiples come down as the sales growth is realized. The exception with Tesla, of course, is that the decline in multiple reversed dramatically from June 2019 to June 2020, rising from 2x to 8x while sales growth was its lowest yet. The table also captures Tesla’s share issuance impact, which detracts from returns by an average of 13% each year.
Note that while the columns sum to the total return column, taking a column average is not technically correct. In the total return column, we show the compounded return, which is what we really want. Unfortunately, there is no good way to get this for the other columns, so we use averages. We note the compound annual return as well to show the error. For stocks with less extreme returns than Tesla, the error is much smaller. There are other ways to work around this, notably the logarithmic return approach taken by O’Shaughnessy Asset Management in Factors from Scratch, but this method works well for our research purposes.
With a return decomposition methodology in hand, we can now start to see what is driving stock market returns. On the following page, I show the annual return decomposition for a sample of US companies from the Russell 3000 that have market capitalization above $300 million. I excluded financials, funds and biotech, which can skew the TEV/sales ratio.
Figure 3: Total Return Decomposition for US Stocks, Market-Cap Weighted
Source: Capital IQ, Verdad
Working from left to right, there are some clear takeaways. TEV/sales multiples are high, but still below the nosebleed levels of 1999 and 2000. The primary driver of stock price returns is sales growth, and, on average, sales growth is 110% of the total return (11% / 10% Total Return). Multiples compress, on average, reducing the sales growth impact by around 20% of the return. While revenues seem to be the biggest driver of returns over the long-term, changes in valuation multiples explain the vast majority of volatility across years.
If 11% sales growth seems high, it is because weighing by market capitalization overweights growing companies. In a dataset that weighs by total sales, sales growth is 6% and multiples expand by 2%. This is a preview of how growth and value work differently, a topic we will explore in future pieces. In both datasets, however, sales growth is declining over time.
Finally, we can see that leverage modestly boosts returns by 1%, while increases in debt and share issuances decrease them by a total of 2%, completely offsetting the 2% benefit from dividends, based on this analysis.
This way of looking at equities is useful for understanding what is going on in specific segments of the market where return drivers can vary significantly. We will explore some of these specific segments in future research pieces.