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:
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, eBay (NAS: EBAY) .
eBay shares returned 76% over the last decade. How'd they get there?
The company doesn't pay a dividend, so you can scratch that off the list.
Earnings growth was remarkably strong. eBay's normalized earnings per share grew at an average rate of 27% a year from 2002 until today. That's almost a magnitude above the broader market average, and frankly an incredible result for any company to achieve. There's no question about it: eBay's earnings have been a huge success over the last decade.
But if earnings were so strong, why were shareholder returns fairly low? This chart explains everything you need to know:
Source: S&P Capital IQ.
eBay was grossly overvalued a decade ago. Ten years of falling valuation multiples ever since have prevented all of the company's earnings growth from turning into shareholder returns. That's an important distinction to make: eBay's mediocre returns over the last decade were fueled by overvaluation in the past, not a deterioration of its earnings.
At nearly 30 times normalized earnings today, shares still don't look terribly cheap. Going forward, far more of eBay's earnings growth will materialize into shareholder returns than in the past, but current valuations still don't leave much room for error, and aren't likely to set shareholders up for remarkable returns going forward. This highlights 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.
Add eBay to My Watchlist.
At the time thisarticle was published Fool contributor Morgan Housel doesn't own shares in any of the companies mentioned in this article. Follow him on Twitter @TMFHousel. Motley Fool newsletter services have recommended buying shares of and writing puts in eBay. Try any of our Foolish newsletter services free for 30 days. We Fools may not 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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