How we analyze returns?
Most portfolio returns are broken down into the three components capital gain, dividend payment and movement in the foreign exchange rate. We developed a method to drill deeper and attribute returns to its true origination such as the expansion of a business, margin improvement, smart buying and selling or simply the cash earned by a company. In this insights report, we provide you with an understanding of our detailed return analysis.
The capital gain
A capital gain refers to the increase of the share price in a given time period. Most people attribute any change in share price to the simple result of demand and supply in the market. We chose a different perspective and decided to get more granular on the capital gain component. Instead of supply and demand, we base our analysis on the companies’ underlying financial performance. Viewed from that angle, there is a lot more to the capital gain than meets the eye. It comprises a firm’s expansion into new markets, its operational efficiency, the market’s valuation of the firm, its capital structure and ultimately the cash the firm earned. We include these factors into our analysis to truly understand what drove our fund’s returns.
Our methodology to understand the capital gain
The analysis is based on an equation that – albeit being quite simple – may not be intuitive when looked at the first time. Hence, we will walk you through it step by step. We will use the example of our past investment in Apple for illustration at every step. The equation has the different factors that drive the stock price on one side and the stock price itself on the other side. So let’s go through the different factors that ultimately determine the stock price.
Our first stop is revenue, the money a company earns with every sale it makes. We invested in Apple in February of 2016. At the time, its revenue was USD 235.0 billion.
When we take all expenses into account as well, we arrive at the operating profit, which quite simply can be written like this:
revenue × operating margin = operating profit
In the case of Apple, the operating margin was 30.3 %. Plugging in the numbers into the equation, we arrive at the operating profit:
USD 235.0 bn × 30.3 % = USD 71.2 bn
The total worth of a company is called the “enterprise value”. This is the number people negotiate over when they sell and buy entire companies. The relationship between the operating profit and the enterprise value is the valuation, which is measured in what we are going to call the multiplier. The multiplier represents the relationship between the annual profit of a firm and the price that a purchaser is willing to pay for that profit. The more she pays in relation to the profit, the higher the multiplier.
Operating profit × multiplier = enterprise value
Returning to our example of Apple, the enterprise value at the time was USD 374.0 billion. The corresponding multiple was therefore 5.3.
USD 71.2 bn × 5.3 = USD 374.0 bn.
Just like you would deduct your mortgage from the value of your house to calculate equity, we deduct net debt from the enterprise value to arrive at what shareholders get. This is also called the company’s market capitalization.
Enterprise value – net debt = market capitalization
At the time when we bought Apple’s stock in 2016, the company had more cash than debt. In this case, the net debt was actually negative. Expressed in our equation, this would look like this:
USD 374.0 bn – (USD –152.8 bn) = USD 526.7 bn
Depending on the capital structure of a firm, a rise in enterprise value can lead to a leverage effect. Should the enterprise value increase while its net debt stays constant, then the market capitalization may increase by the same amount, however, the relative change can be bigger or smaller. We provide an example thereof in the footnote*.
Finally, as the word “share” implies, buying a stock means we only own a share in the business. Hence, the market capitalization divided by the total number of shares equals the share price. In aggregation, this can look something like this:
[ (revenue x profit margin) × multiplier – net debt ] /
number of shares = share price
We can now plug in the numbers for Apple to see our purchase price back in 2016. The number of shares of Apple back then was 5’545 billion.
[ (USD 235.0 bn × 30.3 %) × 5.3 – (USD –152.8 bn) ] /
5’545 = USD 95.00
What looks like a simple equation gets interesting very quickly though! With any move in the share price, we can now see what correspondingly changed on the left side of the equation. The changes within a day are usually simply driven by perception – the supply and demand – which is represented by the multiplier, which in turn shows how much people are willing to pay for a given profit. Over a period of five years though, the revenue of the company has likely changed, it may have bought back shares, changed its debt structure or its operating margin may have improved or deteriorated. Now the fun begins. We can now precisely attribute what factors drove the change in share price.
An analysis from this perspective expands the three initially introduced factors capital gain (CG), dividend (DY) and foreign exchange (FX) to eight factors as shown in the following table.
* A change in enterprise value can result in a leverage effect. This is best explained using an example. Let’s assume a company has an enterprise value of 100 Swiss francs consisting of 50 francs of debt and 50 francs of equity (market capitalization). Should the valuation increase by 20 % while the operating profit stays unchanged, then we arrive at an enterprise value of 120 francs [= 100 × 120 %]. Net debt is still 50 francs. Hence that market capitalization rose to 70 francs [120 – 50 = 70], which is a change of +40 % over the previous 50 francs. In this example, 20 % of the return can be allocated to valuation and 20 % to the leverage effect.