A Brief History of ADP's Returns

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Despite constant attempts by analysts and the media to complicate the basics of investing, there are only three ways a stock can create value for shareholders:

  1. Dividends.
  2. Earnings growth.
  3. Changes in valuation multiples.

In this series, we drill down on one company's returns to see how each of those three has played a role over the past decade. Step on up, ADP (NYS: ADP) .

ADP shares returned 21% over the past decade. How'd they get there?

Dividends helped quite a bit. Without dividends, shares lost 12% over the past 10 years.

Earnings growth was slow but acceptable. ADP's normalized earnings per share grew by an average of 4.3% a year from 2001 until today. That's below the market average and that of smaller rival Paychex (NAS: PAYX) , but at least above the rate of inflation, providing investors with real earnings growth during one of the most difficult economic decades in modern history.

Now have a look at ADP's valuation multiple:

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Source: S&P Capital IQ.

Like so many other companies, ADP was overvalued 10 years ago. Expectations were too high to meet, and so valuations have since dropped considerably. That's prevented a lot of the company's earnings growth over the past decade from turning into shareholder returns -- and remember, that growth was already tepid to begin with.

Things are different today. Shares are more reasonably valued, and the company is still on sound footing. ADP is especially popular with investors because of its strong dividend policy. The coming 10 years should be far better than the past, but ADP's dismal decade is a good reminder of one of the most important lessons in investing: Starting valuations determine future returns.

Why is this stuff worth paying attention to? It's important to know not only how much a stock has returned, but where those returns came from. Sometimes earnings grow, but the market isn't willing to pay as much for those earnings. Sometimes earnings fall, but the market bids shares higher anyway. Sometimes both earnings and earnings multiples stay flat, but a company generates returns through dividends. Sometimes everything works together, and returns surge. Sometimes nothing works and they crash. All tell a different story about the state of a company. Not knowing why something happened can be just as dangerous as not knowing that something happened at all.

At the time this article was published Fool contributorMorgan Houselowns shares of Paychex. Follow him on Twitter,@TMFHousel.Motley Fool newsletter serviceshave recommended buying shares of Automatic Data Processing and Paychex. Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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