Lesson 3 of 7
Neff's total return ratio
John Neff added earnings growth to dividend yield and divided by the P/E. See where a low multiple with a dividend beats a glamour stock on his arithmetic.
By Javier Sanz
Founder of ValueScreener. Built Ninety Nine, a securities services provider, and sold it to a tier-one global bank; ran operations and internationalization at Alpaca, the brokerage API.
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In one minute
- Neff's total return ratio adds earnings growth to dividend yield, then divides by the P/E.
- A slow, dividend-paying stock on a low multiple can score higher than a fast grower on a high one.
- The ratio treats a point of growth and a point of yield as equally valuable, which is a choice, not a fact.
John Neff ran the Windsor Fund on low-multiple stocks most investors passed over, buying steady, often unglamorous businesses that paid a dividend while the market waited for a growth story elsewhere. His total return ratio is the arithmetic behind that choice: growth plus yield, divided by what you pay for a dollar of earnings.
Neff's ratio for three companies
- 7% growth + 4% yield, 10x P/E1.10
- 10% growth + 2% yield, 15x P/E0.80
- 15% growth + 0% yield, 30x P/E0.50
Growth plus yield, over the price
Neff's total return ratio equals Earnings growth rate + dividend yield divided by P/E.
Example(7 + 4) ÷ 10 = 1.10
Growth and yield are both stated as percentage points and added together before dividing by the multiple. A company growing earnings 7 percent a year, yielding 4 percent, on a P/E of 10, scores 1.10. Neff's practice favoured the highest scores this arithmetic produced.
Where the fast grower loses
A 15 percent grower with no dividend, priced at 30 times earnings, scores 0.50, well below the slower, dividend-paying company above. C's numerator, 15, is not far above A's 11, but its P/E is three times A's. Paying 30x for 15 percent growth is what pulls the ratio down.
Why a dividend counts at all
Adding the yield to the growth rate is a deliberate choice, and it is the part of Neff's ratio a pure growth investor would object to. The arithmetic itself counts a dividend as return already paid in cash, while the growth rate is a forecast. A stock that pays you while you wait needs less from the growth line to score well.
What the ratio assumes
The formula treats one point of earnings growth and one point of dividend yield as worth exactly the same. That is Neff's own choice, not an arithmetic necessity, and a reader who values growth or income differently would weight the two terms apart. The ratio also takes the growth rate as given: whether that growth is likely to continue is a separate question the payout ratio and the underlying business answer, not this formula. A high yield that is not covered by earnings is not the same as one paid comfortably out of them, and the ratio on its own cannot tell the two apart. The growth input is a forecast. At 20 percent growth instead of 15, company C scores 0.67, not 0.50.
Check yourself
What two figures does Neff add together in the numerator of his ratio?
- Earnings growth rate and buyback yield
- Earnings growth rate and dividend yield
- Revenue growth and gross margin
Show the answer
Answer: B.
The numerator is the earnings growth rate plus the dividend yield, both stated in percentage points.A company growing 15 percent with no dividend on a P/E of 30 scores lower than one growing 7 percent with a 4 percent yield on a P/E of 10. Why?
- Because a zero dividend always scores zero regardless of the P/E
- Its P/E of 30 is large next to its growth of 15
- Because Neff's ratio ignores growth entirely
Show the answer
Answer: B.
0.50 against 1.10: the faster grower's own price, a P/E of 30, is what pulls its ratio down.Company D grows 5 percent, yields 8 percent and trades at 10x, but pays out 150 percent of its earnings. What does the ratio of 1.30 miss?
- That the P/E is too low
- That the yield is not covered by earnings
- That growth is counted twice
Show the answer
Answer: B.
The ratio adds the yield whether or not earnings pay for it; the payout ratio is the check.Sources
- Neff with Mintz, John Neff on Investing, 1999: the total return ratio, earnings growth plus yield over the P/E.
- Lynch with Rothchild, One Up on Wall Street, 1989 (millennium edition 2000), chapter 13: the same arithmetic, long-term growth plus yield over the P/E.
What this leaves out
- All three companies and their inputs are round invented numbers, not filed figures.
- The ratio weighs a point of growth and a point of yield equally. Not every investor would accept that trade.
- It says nothing about whether the growth rate or the payout is likely to continue.
- Nothing here is advice about any security.