The way to calculate how investment returns come about is quite easy. It is simply the dividend yield plus earnings growth plus change in multiple of earnings the share trades at.
It's easy to guess the dividend yield, harder to guess earnings growth and impossible to know what multiple a share will trade at in the future.
If, over the course of a year, a share changes from trading at 20x earnings to 22x earnings then that's a gain of 10%. If you add in a 5% yield and 10% earnings per share (EPS) growth then that could be a return of 25% in just 12 months.
Being able to identify which businesses the market isn't as excited about as it could be in the future may lead to impressive returns. Here are two shares that could profit from an earnings re-rating:
Specialty Fashion Group Ltd (ASX: SFH)
This business is in the process of selling all but one of its retail chains. It's selling Millers, Katies, Crossroads, Autograph and Rivers for $31 million, but it's keeping City Chic.
The businesses it's selling were actually losing money, so this will improve the profitability of Specialty Fashion and allow it to re-invest into City Chic.
City Chic is forecast to grow its revenue by over 22% between FY16 and FY18. It also improved its earnings before interest, tax, depreciation and amortisation (EBITDA) margin from 7.5% to 10.5% and earnings before interest and tax (EBIT) margin from 4.4% to 7.3% in the period from FY16 to the end of December 2017.
Around 37% of City Chic's sales are done online and it's growing in the USA and Europe.
There's a lot to like about the new Speciality Fashion Group and it could start paying a dividend too.
Greencross Limited (ASX: GXL)
Greencross is an unpopular business with the market at the moment. Its new CEO has come in and written off or written down a variety of things. This should probably have been done in the past but the new CEO has cleared the decks.
Investors are worried that online retail could hurt its Petbarn profit margins and it was also concerning that standalone vets saw a reduction in like for like sales.
However, overall revenue and like for like sales had increased by 9% and 4.5% respectively according to the trading update. I think this means that the FY19 result will show a strong improvement of profit due to the write-downs in FY18.
The co-location strategy of putting a vet inside a Petbarn is a good idea to improve sales and save on costs. The company estimated it would take two or three years for each co-location to reach full earnings. So, by the time FY19 finishes we could start to see the fruit of the investments it has made.
In my opinion if Greencross can show it can get back to sustainable profit growth in a year from now investors will be happy to pay a higher multiple than the current 11x FY19's estimated earnings.
Foolish takeaway
If the management teams can pull off their ideas then there's a good chance by the end of FY19's reporting season that both businesses could have reported a pleasing jump in profit and that would mean investors are more likely to pay a higher multiple for the earnings, leading to good returns. And don't forget about the decent dividend that both shares could pay too.
