Growing up I had a knack for sharing any new piece of information I had learned. This intellectual terrorism took its most insidious form during my dinosaur phase when family members were routinely tortured with the latest facts about theropods and how to pronounce their names (say Archaeopteryx three time as fast as you can). Though my love of dinosaurs has never subsided, I eventually began to bother people with more socially palatable topics such as the market and economics.

One such episode occurred back in high school when I started to lecture my dad about a particular stock he should by. Then he asked, “Why?”

“Well, it’s going up and Yahoo Finance (this is in 2009) says it will continue to go up.”

Then my dad did the unthinkable. He asked, “Why do they say it will continue to go up?”

Two “Whys” and I was stumped. I have since learned if you can’t defend your position after a minimum of three “Whys?” then you probably had no idea what you were talking about in the first place. But instead of making fun of me for parroting garbage investment commentary, my dad took the time to review a simple tool he uses when analyzing the total return opportunity for an investment.

As you probably guessed, we call it the PIG formula. The PIG formula is broken into the three components of investment return:

Price: This is the metric for how assets are valued. Most investments sell at a multiple of their income. For stocks, it is called the price to earnings ratio and for real estate it is price to rent ratios.
Income: This is either interest, dividends, or rent.
Growth rate: This measures the increases in the income or earnings of a company or real estate.

Our objective in using and understanding the PIG formula is to sum the three components (Price, Income and Growth) to allow us to estimate the return potential of an investment. We’ll start with the most reliable of the three, which is Income and by doing so I am going to sidestep the conversation over whether investors should prefer dividends to stock buybacks (which would be a function of a changing Price).

When discussing Income, we are talking about the cash return from interest for bonds and dividends for stocks and rent from real estate.

The next on our list is Growth, which is the rate at which earnings and income increase over time. In real estate, growth can occur when the owner increases rents. For stocks, it can be a combination of price increases for the goods and services the company provides, as well as an increase in the number of services and goods sold.

Finally, we get to the factor we have the least confidence in, which is Price. With Price we are trying to compare the current Price metric to an estimated future Price metric. Let me illustrate how this works. Let’s assume we like a stock that is selling for $100 and the expected earnings are $10. Our Price metric is the Price to Earnings ratio, which equals 10. To estimate our future return on this stock, we need to make an estimate of what the future Price to Earnings ratio will be. In most of our evaluations, we assume we own an investment for ten years. Here is how we would estimate the return potential of the stock discussed.

Let’s assume the $100 stock provides Income of $3.00 per year (dividend). Let’s also assume the company has grown earnings and increased the dividend by 5% for the last decade and we believe the Growth rate of earnings and the dividend will remain at 5%. The final assumption is that we assume the Price to Earnings ratios in year ten, will increase to 12. With this information, here is the return estimate for the stock.

Income 3% ($3 dividend divided by the $100 stock price)

Growth rate (5% as discussed above)

Price change (We buy the stock at 10 times earnings and expect to sell it at 12 times earnings in 10 years. This is a 20% increase over ten years. In simple compounding, we have a 2% per year return, compounding would provide a return slightly less than 2%. For illustrative purposes, let’s call Price return 2% per year)

If the stock provides a 3% dividend, grows earnings at 5% and the Price change is 2% our forecasted return is 3+5+2=10% return.

Now, I used a stock in my example, but the PIG Formula works across the board. Below is a table of several asset classes and where they fit in the formula.

Is PIG perfect? Not quite since it’s short on discounted cash flow analyses. However, it is so simple and intuitive it has become part of my subconscious analysis when hearing people discuss fads or legitimate ideas. I hope it proves useful to you as well.

What I’m Reading and Watching

Life may be weirder than you think: One thing I loved about Avatar: The Way of Water was its intelligent whales. This pairs with a new study claiming T-Rex may have been as smart as modern primates. Impossible to verify, but I like the idea of a house-sized and problem-solving dinosaur terrorizing prehistoric North America. I don’t think I will ever stop sharing useless but fun information about theropods.