Regarding Returns

Came across this statement in one of the porfolio updates which is featured in one of Malaysia's "leading" financial and business publications.

"Last week, Yi-Lai's shares traded ex for a 5 sen dividend, which we have adjusted accordingly. Yi-Lai has been a high dividend yielding stock. Since we bought these shares at RM1.03 in June 2003, we have received total dividends of RM0.545 per share, bringing our cost down by 53% to RM0.485. Against its current share price of RM1.15, our returns now stand at 137%."

Now, let's put aside the Time Value of Money for a moment, although it's arguably the most basic tenet of finance and investment (Why? Because 100% over 10 years is a helluva lot of difference from 100% over 1 year, for example). Forget about that, let's take the statement at face value. A return of 137% over a period of about 40 months (June 2003 to October 2006) is certainly a respectable feat and not to be sneered at.

But waaaiiiitt...., what's that about dividends received "bringing our cost down by 53% to RM0.485"?! So it seems that the 137% return was achieved by DEDUCTING RM0.545 (total dividends received over 40 mths) from 1.03 (the purchase price) to arrive at a brand-spanking-new cost of, get this.... 0.485! Now, isn't that a nice, small, low number? So, proceed to take the current price of 1.15 (which is actually 11.6% above the 1.03 initial cost after 40 mths) over the new cost price and wallah....137% returns are yours to book in!

Now, let's think about the concept of investment. One puts in a certain sum which represents the cost and anything else received or paid back to you after that represents your return, right? Isn't it as simple as that? If you deposit money into a bank and after 12 months it pays you 8% interest, isn't your return 8%? Do you say no, let's put that aside as cost reduction first? What kind of financial concept is that? Then, isn't it the same for all financial investments?

What if, instead, we considered dividends received in the example above as part of total returns instead of "cost reduction"? Well, adding the 11.6% capital gain to the 52.9% return from dividends to date would give a total return of 64.5% over 40 months. Still decent, but a far cry from 137%, right? (In fact, it's less than half).

Just to press this point further, let's take the above cost reduction example to the extreme. Assuming the model portfolio in question does not dispose of this share in the interim, it's entirely possible to receive another RM0.455 in total dividends over the next 3 years. Following this reasoning, the new adjusted cost would be RM0.485 - RM0.455 = RM0.03. Assuming then that your wonderful stock suddenly plummets from RM1+ down to RM0.33 on some really bad news.... would you be worried? Of course not, just sell the damn thing, take your 1,000% return (RM0.33 / RM0.03) and give yourself a nice pat on the back. After all, not every ordinary Joe regularly pockets 1,000% returns, you know ... you've done well for yourself.

/ichithekiller

p.s. Since I'm no mathematical or financial genius, if I've made any errors in calculation or assumption, please let me know. I will gladly change my views if I can be shown the error of my ways. I too would like to get to the bottom of this mystery as to why investment professionals and amateurs alike regularly condone and use this type of return calculation for individual stocks.

p.p.s On a total return basis, i.e. total $$$ at the end of the day, the piggy bank balance would be the same, though, whichever method of calculation is used.