In my April 10 Money and Markets column, I explained that the first building block all successful investors must have to grow their next egg is a Better Investment Model. This means kicking the concept of luck to the curb and fine-tuning your investment process so you can confidently apply it to any future investments you make.
In a perfect world, you’d want a model that is easy-to-understand, accurate and comprehensive, and will show the expected return from an investment using some basic inputs.
Well, the model I’m about to give you does exactly that! It’s powerful and elegant, yet simple to understand. You should add it to your investor tool kit because when properly applied, it can lead to great financial reward.
This one model can tell you more at a glance than reading multiple financial publications or spending countless hours on the Internet, sifting through information that is of little or no value.
|When investing, you want to eliminate as much guess work as possible.|
3 Factors to Determine Your Returns
This model has three — and only three factors. And these three can be used to determine the return on any investment you own. It doesn’t matter whether it’s a stock, a bond, a mutual fund, a currency holding, or a commodities contract.
The three factors are:
(1) Current yield
(2) Growth rate
(3) Revaluation or change in P/E multiple
All three factors are expressed as a percentage. And all you have to do is add them together to get your expected total return number. And better yet, you’ll know one of the factors — current yield — at the time of the investment. So you only have to estimate the growth rate and revaluation percentages.
Note however, that currencies and commodities have just one element and that’s revaluation; non-dividend paying stocks have two elements — growth and revaluation; bonds have two elements — yield and revaluation.
So the model can be used for anything, it’s just that certain financial instruments don’t have all three factors.
Now I’ll give you an example to help you understand how this model works. Let’s do a quick analysis to estimate the annual total return you might expect from United Technologies (UTX).
Technologies is a $54 billion conglomerate with business operations serving primarily the construction and aerospace markets. Otis elevators, Carrier air conditioners, Pratt & Whitney engines, and Sikorsky helicopters are key United Technologies product lines.
Morningstar reports that with roughly 20 percent exposure to the emerging markets, United Technologies has growth tailwinds, which should help the firm grow in the event of slow growth in the U.S. and Europe. A number of United Technologies’ businesses are still below their peaks from 2008 with ample room to grow sales and net profits.
Today, United Technologies has a dividend yield of approximately 2.2 percent and trades at a price-to-earnings ratio of about 14.2. Let’s say that we expect earnings to grow at 12 percent over the next year and the P/E multiple to expand to 16.5.
Using the model I described above, we get the following estimated annual return:
Current Yield: 2.2 percent
Growth Rate: 12 percent
Revaluation: 16.2 percent (a change in the P/E multiple from 14.2 to 16.5)
Total Estimate Return: 30.2 percent
That’s all that is required! Add the current yield, the growth rate, and the revaluation percentage together and, presto, out pops an estimate of the total return for the investment — in this example, it’s 30.2 percent for UTX.
United Technologies is currently on my watch list for inclusion in The Park Avenue Society’s Elite Eight Portfolio. The Elite Eight is the best-of-the-best, cream-of-the-crop larger cap stocks selected from a Nifty Fifty list of the highest-quality, best rated U.S. stocks.
Of course there is much more to picking investments than estimating your return, nonetheless, it’s an excellent starting point.
Would you like to follow along as my team and I use this same model as part of our overall strategy for investing America’s wealthiest families’ money in these tricky times?
Just click here now to learn how you can shadow our every move.