Investors have probably heard that past performance is no guarantee of future results. When buying stocks, this idea can work both ways. A stock that has rallied for several years may reverse course in the future. Conversely, a beaten-down stock could produce outsized returns, if it completes a successful turnaround.
Ultimately, a stock’s expected total returns are derived from three sources: a company’s earnings growth, its dividends paid, and any upward or downward changes to its valuation multiple. Food and beverage giant Kraft-Heinz Co. (KHC, Financial) is an excellent stock to view the interplay of the three sources of expected total return.
While Kraft-Heinz stock has had a rough ride lately (shares have lost 26% since the beginning of the year) this does not mean its total returns will stay negative going forward. Quite the opposite — Kraft Heinz could generate strong returns of 10% per year for shareholders.Â
What is expected return?
Expected return is the anticipated future return of a stock over a given time period. It includes all capital gains (or losses) and any dividends paid. Capital gains refer to the increase or decrease of a stock price after the investor purchases shares. In the short term, share prices fluctuate for any number of reasons. But over the long term, the drivers of a rising or falling share price are a company’s earnings growth or decline, and any changes in the valuation multiple (typically measured as price-earnings ratio).
In Kraft-Heinz’s case, the stock has declined significantly over the past year, as the company’s profits are under pressure from acquisition expenses, as well as rising costs of raw materials. But the biggest driver of Kraft-Heinz’s falling share price is a declining valuation multiple. Slowing growth has turned market sentiment much more negative toward Kraft-Heinz.
Kraft-Heinz is struggling due to changing consumer habits. Consumers are increasingly avoiding packaged foods in favor of healthier alternatives like organics and natural foods. This has slowed Kraft-Heinz’s sales, and consequently, investors have soured on the stock. As a result, Kraft-Heinz has delivered negative total returns over the past year. While this has been difficult for Kraft-Heinz shareholders up to this point, it could serve as a good buying chance moving forward.
How Kraft-Heinz returns above 10% per year
Kraft-Heinz stock could produce double-digit returns annually for shareholders over the next five years due to a combination of earnings growth, valuation changes and dividends.
First, while Kraft-Heinz’s growth has slowed in recent periods, the company is still raising earnings. In fact, Kraft-Heinz grew its adjusted earnings per share by 2% in the most recent quarter. The company’s earnings per share rose by 4% through the first half of 2018. Accelerating growth from cost cuts and share repurchases could allow it to generate 5% annual earnings growth over the next five years.
In addition, Kraft-Heinz stock appears to be undervalued. It trades for a price-earnings ratio of 15.2 based on expected earnings per share for 2018. This is below the average valuation for Kraft-Heinz in recent years. Since the merger of Kraft and Heinz in 2015, the stock has traded for an average price-earnings ratio of 22.5; even assuming a more modest valuation multiple of 17, the stock is valued at a discount.
There is potential for the valuation to expand going forward, though, as the company works through its turnaround. If the price-earnings ratio expands to 17, it would boost annual returns by 2.3% per year.
Last, Kraft-Heinz pays a dividend. The current dividend yield of 4.4% is very attractive for investors interested in dividend income. This is more than twice the average dividend yield of the S&P 500 index. And a high dividend yield is another positive outcome from a falling share price, as dividend yields rise when share prices decline.
Assuming the dividend remains intact, investors buying at the current price will earn an annual return of 4.4% from dividends.
Adding it all up, Kraft-Heinz’s total expected returns are 11.7% per year going forward, comprised of earnings growth, an expanding valuation multiple and dividends. This is a satisfactory rate of return for a high-quality company with strong brand power and durable competitive advantages.
Disclosure: I am not long any stocks mentioned in this article.
