Equity Valuation and Portfolio Management

FUNDAMENTAL STOCK RETURN

Another useful traditional measure of corporate success arises from the relationship between the fundamental return on a company's stock and its ROE. The fundamental stock return (FSR) is equal to the sum of the assessed dividend yield (DY) and the internal capital generation rate (ICGR). In formal terms, the FSR can be expressed as

In this expression, DPR is the firm's dividend payout ratio, while D/P is the assessed dividend yield on its common stock. In turn, PBR is the “plowback ratio,” measured by one minus DPR. Since PBR is the fraction of earnings that are retained by the firm for investment in real assets, the FSR shows how internal growth is related to financial happenings at the company level.

That is, the firm's internal capital generation rate (also called the sustainable growth rate) derives its value from the product of the fraction of earnings retained for future investment—which reflects additional equity capital resulting from reinvestment of a firm's profit—and the estimated return that the firm's managers can generate on those retained earnings. ROE in the traditional realm of financial analysis measures that likely return on stockholders' equity. As we argue below, the FSR should be compared to the investor's required return (or cost of equity) to see if the return that a company can deliver from its underlying fundamentals exceeds or ...