by Jeff Borack, Learning Markets Contributor
Investors understand that earnings and growth are good, but the relationship between earnings, growth, and value is misunderstood. The P/E ratio, a universal symbol of value investing, is itself a bastardized form of the Gordon growth model. The PEG ratio is even worse. What does matter is how much value the companies we invest in return to us in the future. Without a crystal ball, we’re forced at least in part to guess what’s ahead by looking in the rear-view mirror. The least we can do is make sure objects aren’t closer than they appear. We can only do this by having a logically consistent understanding of investment returns.
A company generates earnings, which are valuable and important, but if we plan to own shares for more than a quarter, what we really care about is what management does with those earnings. They have four choices, a) hold the cash (or repay debt), b) pay a dividend, c) repurchase shares, or d) reinvest in the business.
Learn more about these concepts in the videos below.
- Turbocharge your dividends
- What is a stock buyback? Check this out (it's free!): Stocks You Should Be Watching Right Now; How to Make Good Picks
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Essential Reading for Traders
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| | | | | Cash
Holding cash (or repaying debt) shouldn’t create or destroy value. Foreign exchange traders would disagree, cash held in a foreign currency can fluctuate in value, changing your purchasing power. Also there’s an optimal capital allocation argument, with the tradeoff being default risk vs. tax shield, and a positive cash balance is like negative leverage. Cash is also confusing when we start talking about enterprise value vs market cap valuations. We should be willing to pay more for a business with cash on the balance sheet than an identical business without it, but the tradeoff isn't 1-1, and estimating the true value is a matter of judgment. But this isn’t my focus today. As far as we’re concerned, retaining cash should generate (or offset) just enough interest that it’s a breakeven proposition and we're going to focus on the three other forms of return.
Dividends
Dividends are one of the key ways in which an investment returns tangible value to shareholders. A bond’s coupon payment is equivalent to a dividend. Even if the bond trades at par value forever (i.e. never appreciates) it still returns value to investors by yielding some percent. Stock dividends are the same thing. Some investors don’t like dividends because it forces them to pay tax on the proceeds immediately, but dividends have advantages over other forms of return in that they’re transparent, easy to value (a $5 dividend is worth $5), and they generally send a signal that management believes the current dividend payments are sustainable (although some dividends are one time and some companies have to reduce or cancel periodic dividends).
An example of a company I looked at for the dividend was International Paper (IP), which had a historical dividend yield of 15%. This allowed me to be highly confident of the upside and focus on the downside risk in the first report I published on my blog.
Share repurchases
Share repurchases are equivalent to dividend payments. The company is taking a portion of its cash and distributing it to shareholders. Shareholders don’t get paid cash, but instead their shares entitle them to a greater portion of future company profits (and therefore future dividends) because the individuals least willing to hold shares relinquished their right to future earnings. If a company’s net income next year is equal to their income this year, but fewer shares are outstanding, earnings per share will rise. If a company’s earnings yield is 10%, they earn $1/share on shares that trade for $10. With 1,000 shares outstanding, they’ve earned $1,000 of net income this year and the enterprise value is $10,000. If earnings are flat next year, but that $1,000 was used to repurchase shares, the company will earn $1,000/900 shares, or $1.11/share because 100 shares were repurchased last year at $10.
Like magic, the same company selling the same products to the same customers at the same prices was able to grow EPS. Investors sometimes criticize management for making large share repurchases before a fall in share price on the grounds that management could have repurchased a greater number of shares for the same amount of money if they had waited. Generally these investors are just sore losers who wish they had thought to sell shares back to management at high prices. Current shareholders obviously expect the share price to continue rising even if the share price already seems high to others. From management’s point of view, shareholders believe the stock is worth the price it’s trading at or more, and therefore should be indifferent between dividends or repurchases. Shareholders can’t be mad at management for repurchasing shares that shareholders themselves believe are fairly or under-valued. However, large repurchases can signal that management believes shares are grossly undervalued.
One of the things I like most about dividends is that they only flow in one direction. Management pays investors money. They never demand that existing shareholders contribute money to continue owning shares. With share repurchases, management sometimes sells shares, which is effectively a negative dividend. It’s managements way of a) forcing shareholders to pay for things the company otherwise couldn’t afford like acquisitions, and b) hiding expenses (such as managements incentive pay in the form of stock options).
Incremental Reinvestment (aka growth)
Reinvesting earnings is the final way in which a company can return value to shareholders. Sources of reinvestment can include CapEx, acquisitions, and R&D. The market often views reinvestment favorably, but it also entails the most risk because management chooses which projects to invest in. A new project can yield the same, more (because of economies of scale), or less (because of the law of diminishing returns) than the existing business. There is also a time delay, whereby capital invested today may not generate returns for many years. A biotech company that earns no income and continually dilutes shareholders while investing heavily in R&D will not appear to be returning value to shareholders, but the technology is growing in value. These situations require special expertise to analyze. The important thing to remember is that reinvestment, despite the inherent risks, returns value to shareholders in the same way as share repurchases, by growing EPS.
An example of a company attractive to me for it's growth is the maker Ugg boots, Deckers Outdoor (DECK). In my analysis, I showed how they have managed to grow the business and a phenomenal rate without significant reinvestment of earnings. This would indicate to me that a dollar in the hands of DECK is worth more than a dollar in the hands of most other companies.
Conclusion
These are management’s only options. Combining each of them is the only way to understand what returns investors can expect in the future. But the most important thing to recognize is that if both share repurchases and growth return value to shareholders by growing EPS, there should be a way to equate them in terms of "value". If share repurchases are equivalent to dividends in the way management makes a tangible distribution to shareholders, we should also be able to equate repurchases to dividends. And finally, if we tie it all together, we should find a way to equate growth to dividends, and select the investments that will generate the highest total return. Over the next few weeks, I’ll build on this to explain how and why investors misuse the P/E ratio and overvalue growth. I'll also show you some shortcuts to avoid miss-pricing different but equal forms of investment return.
Jeff Borack is an analyst with Marathon Partners. His commentary can be seen on his blog and his model portfolio is available here on Kaching.
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