Why Total Return Is More Important Than Increases in Market Capitalization

Don’t confuse changes in market capitalization with the return you earn on your investment. Instead, focus on total return – appreciation in the share price plus cash dividends and any spin-offs or other distributions received. The distinction may seem small to some new investors, but the implications are extremely important.

There are four primary reasons that changes in market capitalization are not an appropriate metric for determining investor’s wealth and can often seriously understate the total return to a shareholder that bought and held stock.

1. The Board of Directors may decide to repurchase shares, reducing the total number of shares outstanding. A company could not grow its overall profit at all yet still compound at a very good rate if the stock price is low enough. For more information read Share Repurchase Programs - The Golden Egg of Shareholder Value.

2. Capital may be returned to shareholders in the form of cash dividends. This won’t show up in the share price because once the checks are mailed, that money is in the hands of the owners, not the company. Yet, as a shareholder, it represents a very real increase in your own net worth.

3. Companies may foolishly use their own stock to acquire other companies when it is undervalued or when the target company is overvalued. This results in a larger empire; that is, market capitalization, but the per share intrinsic value of each share common stock did not increase proportionately and, in many cases, actually decreased despite the rise in the overall market capitalization of the corporation.

4. Subsidiaries or divisions can be spun-off to shareholders resulting in substantial additional wealth that will never be reflected in the market capitalization or share price of the original investment.

Share Repurchases

When a company returns excess profit to shareholders by repurchasing its own common stock, the total shares outstanding may shrink, resulting in a higher percentage of the profits going to each remaining share. Over the long-run, the results can be astounding in terms of the additional wealth provided to the owners who hold on to their stock despite the fact that the overall market capitalization of the overall company may not increase.

Don’t Forget the Dividends - A Few Percentage Points Can Mean Millions of Dollars – Literally!

Imagine you buy 300 shares of Wells Fargo & Company common stock at the current market price of $35.75 through your Roth IRA or Traditional IRA for a total investment of $10,750. After completing your analysis of the company’s financial record, you decide that earnings should grow at 10% for the next ten years. Assuming the price-to-earnings ratio remains constant (which you consider a reasonable probability given the past record, management’s demonstrated ability to allocate capital, and the fact that the current valuation is on parity with the S&P 500 broader market; itself trading at around 15x earnings, the historical norm), you expect the position to grow at the same rate, 10%, to approximately $27,883 a decade from today. Yet, the stock currently boasts a dividend of $1.12 per share, resulting in a dividend yield of 3.10%.

Assuming those dividends are reinvested into the stock – most brokerage firms don’t charge a commission or fee for these automatic reinvestments – the actual return to the investor would be 13.10% per annum. That return would turn your investment into $34,247; that’s an extra $6,364, or 22.82% more money in your in only a decade. An extra three percentage points of return may not seem like much, but over long periods of time, the results are nothing short of staggering. Take, for example, two 25 year old college graduates working in corporate America with identical finances; John and Jane. If John were to invest $10,000 per year, earning 10% for 40 years before retiring at 65, he would end up with $4,425,926 (yes, that’s right – it’s not a typo; yet one more reason to start as early as possible if you can.) If Jane, on the other hand, earned 13.10% during that same time period, she would end up with $10,424,718! That is $5,998,792 more wealth without any more work!

For more information on how reinvested dividends can make an enormous difference, read our articled discussing the work of famed Finance Professor Jeremy Siegel, Why Boring is Almost Always More Profitable.

Companies May Use Their Stock to Acquire Other Businesses

If you own a candy company with a market capitalization of $100 million and you want to buy a competitor which also has a market capitalization of $100 million yet you don’t want to spend the cash, one option would be to issue shares of your company in exchange for shares of the other. The result would be a new, combined corporation with a market capitalization of $200 million. Yet, as an individual shareholder, despite this doubling of the market capitalization, you are no better off; in fact, if the stock of your company was undervalued or the shares of the other company overvalued, you may have actually been the victim of wealth destruction! Too many managers and shareholders simply focus on the size of the domain rather than the profitability on a per share basis and the return on capital earned which are, in my opinion, the only rational metrics.

Some of the best investment returns of the past century have been the result spin-offs. Here’s how it typically works: The Board of Directors of a company decides that a particular division or operating subsidiary no longer fits with the strategic mission of the company, or that it could grow faster as a stand-alone business. Sometimes, a regulatory agency requires a particular part of the business to be sold or spun-off in exchange for approving a merger or acquisition. Whatever the rational, existing shareholders receive stock certificates in the mail or deposited into their brokerage account based upon their proportional ownership (for example, you may receive one share of the new company for every five shares you own now.) When it is done, the stockholder owns stock in both of the companies.

Why do spin-offs tend to perform so well? There are many theories but the most reasonable seems to be that the management team is able to focus on what is best for that particular business only, not the parent company. In addition, they are compensated based on the operating results and stock performance of the business which often is far more motivating than simply being part of a huge conglomerate. Finally, the accounting for a single operation often tends to be far more transparent, making the financial metrics such as return on equity far more competitive with other enterprises in the industry. A candle company that is spun-off from a conglomerate and earns 100% on its tangible net property, plant and equipment with little or no debt is probably going to get a much higher price-to-earnings multiple on its own than the former behemoth of which it was a part.

It really is astounding to stop and consider how many spin-offs grow larger than the company out of which they came. One need only look at Tim Horton; a former operating subsidiary of Wendy’s. Following a partial spin-off and an initial public offering, the business now has a larger market capitalization than Wendy’s itself! Likewise, Sara Lee got rid of Coach, a maker of luxury handbags and formerly a tiny division of which Wall Street took little notice. At the time of this writing, Coach has a market capitalization of $18.5 billion while Sara Lee comes in at only $12.74 billion.

A Few Rules to Remember

There are a few things that you should always keep in mind.

• Never, never, never – under any condition –risk more than you can afford simply for a few percentage points of extra return. The first rule of compounding is that you must have something to compound. Risking your entire retirement account on a penny stock is going to cause you to end up in the poorhouse and, worse yet, you will have lost the capital you contributed through your hard work; at least you could have blown it on a new television or a trip to Vegas!