Business Value
#TSR Decomposition
Even good fundamental indicators do not necessarily mean good profitability for investors, as profitability can affect the investment price of shares, which, apart from fundamental data, depends on market expectations.
Shares of organizations with good ROIC and Growth Rates are generally considered future-oriented, so further increases in the prices of such shares due to future expectations are very challenging – which is better for “fundamentals”, but difficult for their improvement.
By analyzing TSR, we can see what components (including expectations) and with what weight contribute to the overall return.
The traditional formula is as follows:
TSR = % Change in Market Value + Dividends Yield
Where:
TSR = % Change in Net Income + % Change in P/E + Dividend Yield
In this formula, the change in P/E can be considered as a reflection of changes in market expectations, which is often very interesting numerically.
However, the traditional formula lacks several aspects: let’s assume that we compare the TSRs of two companies – what can’t we see?
- Earnings growth can occur in various ways, and not all types of growth result in the same increase in organization’s value, because the amount of capital required for growth and ROIC differ;
- Dividend yield inclusion implies that it leads directly to an increase in future dividends, which is not always the case. The amount of dividends does not necessarily correspond to the value of excess funds. For example, a company may arrange dividends through borrowing, which may not result in an increase in future dividends;
- The formula does not take into account financial leverage effects. Two organizations that create the same value-added “fundamentals” may have different TSRs due to different financial leverages and corresponding risks.
The new formula for TSR decomposition is as follows:
TSR = %Change in Revenue – (E/P) * (Growth/ROIC) + Impact of Change in Profit Margin + Net Income/Market Value + % Change in P/E
In this formula, fundamental indicators are introduced, and the contribution of leverage to TSR is left out. Also, instead of Dividend Yield, there is Earning Yield, i.e., profitability in zero growth situations, and finally, the consideration of leverage effect is possible if Unlevered P/E is used instead of the traditional P/E in the formula.
Below is a table showing that the annual TSRs on stocks ranged from 18% to generating 1.4%, with profitability at 10%, leverage at 3.6%, and changes in earnings at 3%.
#VALUATION – Measuring and Managing the Value of Companies, 7th Edition;
McKinsey & Company, Tim Koller, Marc Goedhart, David Wessels
