One of the recent feature requests we've had as part of Stockopedia PRO is to provide Total Shareholder Return charts over different timeframes - that got us to thinking a bit more about TSR and why it's useful. What's interesting is that you don't see TSR on that many data websites (for stocks, at least - funds is a different story) but you can usually find it on individual company websites, not least because it's a big element in management compensation packages! According to Management Today, in the majority of FTSE 100 companies, performance against this measure is now used as the basis for calculating the major component of directors’ bonuses.
What is Total Shareholder Return?
Share-price based measures like relative strength are all very well but, when assessing stock market investments, it’s important not to fall into the trap of just looking purely at share price movements, while ignoring the value of dividend income. Total shareholder return (TSR) is intended to be he ultimate bottom line of investment performance. It measures the full returns earned by an investment over the period of ownership, including any dividend cashflows paid during that period. In essence, total shareholder return is the internal rate of return (IRR) of all cash flows paid to investors during a particular period.
Over a short time-frame, a company’s TSR may not mean all that much but, over the long-term, it is arguably the single best indicator of comparative investment success because it reflects how well a company has created value for shareholders in highly competitive capital, labor, and product markets. That said, the fact that actual equity returns are usually below the theoretical TSR highlights one of the most significant advantages and risks associated with investing strategies – namely, the gains from the power of compounding, once described as the eighth wonder of the world by Warren Buffett, and the related risk of not reinvesting your dividends.
How do you calculate TSR?
In its simplest form, TSR has two components, the price appreciation rate (i.e. End Share Price - Opening Share Price / Opening Share Price) and the dividend yield (Sum of Dividends per Share / Opening Share Price). As an example, let’s imagine that a shareholder in Company X invests £1.5 at time t, and at time t + 1 the share is worth £2, while the sum of annual dividends over that period has amounted to £0.2. In this case, total shareholder returns are equal to (2 - 1.5)/1.5 + 0.2/1.5 = £0.7/1.5, which is a 46% TSR return on the initial investment of £1.5. In some cases, the dividend yield will be low or negligible, meaning that the share price movement will be the key driver of TSR, but, in traditionally higher-yielding sectors (e.g. utilities or tobacco companies), the dividend component will be more significant.
Nuances & Issues
While this idea may seem simple, there are some important nuances to consider in the calculation of TSR:
- Special Cash Payments - It’s important to note that "dividends" should include not only regular dividend payments, but also any other cash payments to shareholders (e.g. special or one-time dividends or share buybacks). In addition, the share price should be adjusted to strip out the impact of any stock splits, as this is just an accounting issue and does not reflect any change in underlying corporate value.
- Time Period Dependent - A TSR over a five year period can look very different from a TSR measured over a one month or ten- year period. Generally, the period of analysis should be at least a full twelve-month period. This will provide a more accurate snapshot of the performance of the stock by allowing for seasonal ups and downs and also temporary factors that may have caused a short term rise or fall in the value of the shares.
- Averaging Period for Stock Return - Applying an averaging period to the beginning and end of the stock price movement calculation can help to avoid the biasing effect of one-off unique or seasonal events (e.g. news releases or seasonal effects), which may impact a more simplistic spot TSR calculation. This can range from a few days to as much as as 200 days. However, while a long averaging period mitigates share price volatility, it may also result in a theoretical TSR that may not really reflect genuine returns to shareholders, and it also makes the calculation more time-consuming. The ABI advises that the averaging period should be “over a short period of time.... Lengthy averaging periods should be avoided”. Some companies also use a Volume Weighted Average Price but this is only likely to be necessary for extremely thinly traded stocks.
- Dividend Reinvestment Timing - As we've discussed elsewhere, there are 4 key dates to be aware of, with respect to dividends. Theoretically, the TSR calculation should assume that dividends are re-invested on the Ex-Dividend Date, as it should take account of only the dividends that the period of ownership of the stock entitles us to receive (it could be that the investor owns the stock on the day when the dividend is actually payable, but they would only be entitled to receive it if they owned the stock on the ex-dividend day).
Key Steps for Calculating TSR
We're planning to model the TSR for all UK stocks as part of Stockopedia PRO, so, putting these elements together, the key steps for calculating TSR looks to be as follows (comments welcome):
- Decide on the Measurement Period (e.g. January 2008 - December 2010) and the Averaging Period (e.g. 10 days)
- Ascertain any dividends (or dividend-like payments) during the Measurement Period, the relevant ex-dividend days and the share price on those days
- Calculate the Accumulation Factor (i.e. the accumulated number of shares, assuming all dividends are re-invested on the ex-dividend date).
- Calculate the average Asset Value at the Beginning and at the End of the period
- Multiply the average End Asset Value by the Accumulation Factor
- Calculate the TSR % based on the ratio of the adjusted End Asset Value to the Beginning Asset Value.
We'll be modelling the TSR for all stocks as part of Stockopedia PRO.
All that glitters is not gold
While the TSR is very useful, it can be somewhat deceptive, as Michael Mauboussin at Legg Mason Capital Management points out. The number that matters to an investor is his total equity return or capital accumulation rate. The TSR will equal an investor’s capital accumulation rate only when all dividends are reinvested back into additional shares of the company.
This assumption of full dividend reinvestment is rarely valid in practice. The capital accumulation rate will be well below the TSR if a shareholder decides to consume dividends - it's only the rare investor that can afford to reinvest all dividends and sell no shares over a lifetime. Estimates by Al Rappaport suggest that investors who directly own individual stocks reinvest less than 10 percent of the dividends they receive, and spend the rest. This is in spite of the fact that many large companies offer a dividend reinvestment program at little or no cost. Another related issue with the TSR that Rappaport notes is that that:
the remarkable historical growth in accumulated capital from reinvested dividends can mistakenly persuade some investors that dividends, rather than price appreciation, govern investment performance".
While departures from 100% dividend reinvestment have a major impact on capital accumulation, Rappaport argues that, once investors make the dividend reinvestment decision, capital accumulation depends entirely on price appreciation.
A final problem with TSR is that it doesn’t make any allowance for the risk profile of the investment. Two firms may have the same TSRs and yet one may be a lot riskier (e.g. because of greater cyclicality). This is a particular concern when using TSR for the setting of incentive schemes for executives. The danger is that company managers may be tempted to try to achieve higher TSRs by taking on greater risk.
A stock's TSR is worth focusing on because it factors in both capital growth and dividends - it's the bottom line for how well a company has done for its shareholders. However, as we've just seen, there are some nuances to getting the calculation right. it's also important to remember that, contrary to its name, TSR does not represent the actual return earned by a typical equity investor. Instead, it is the theoretical capital accumulation rate assuming full dividend reinvestment and, in reality, returns tend to be lower for most investors.
- Dividend Reinvestment, Price Appreciation and Capital Accumulation
- Valuation Relative Total Shareholder Return Plans
- A How-To Guide On Calculating Total Shareholder Return
- Plan Design Considerations With Performance Shares Using Relative Total Shareholder Return
- Arnold:The Handbook of Corporate Finance
- Morningstar TSR Calculation Background
- Angels, Pinheads, Capital Gains and Dividends