Tag Archives: sales

The Two Sides Of Total Investment Return

By Quan Hoang I spend about 10-15% of my time crunching data. That sounds tedious but I actually enjoy this task. It forces me to pay attention to details, checking any irregularity I see in the numbers and trying to tell a story out of the numbers. My recent work on Commerce Bancshares (NASDAQ: CBSH ) led me to ponder the relationship between ROIC and long-term return. Over the last 25 years, Commerce Bancshares averaged about a 13-14% after-tax ROE, and grew deposits by about 5.6% annually. Over the period, share count declined by about 1.9% annually, and dividend yield was about 2-2.5%. Assuming no change in multiple, a shareholder who bought and held Commerce throughout the period would receive a total return of about 9.5-10%, which is lower than its ROE. Why is that? Chuck Akre once talked about this topic: ” Mr. Akre: What I’ve concluded is that a good investment is an investment in a company who can grow the real economic value per unit. I looked at (what) the average return on all classes of assets are and then I (discovered) that over 75-100 years that the average return on common stock is around 10%. Of course this is not the case for the past decade but over the past 75-100 years, 10% has been the average return of common stocks. But why is that? Audience A: Reinvestment of earnings. Audience B: GDP plus inflation. Audience C: Growing population. Audience D: GDP plus inflation plus dividend yield. Audience E: Wealth creation. Audience F: Continuity of business. Akre: …what I concluded many years ago, which I still believe today, is that it correlates to the real return on owner’s capital. The average return on businesses has been around low double digits or high single digits. This is why common stocks have been returning around 10% because it relates to the return on owner’s capital. My conclusion is that (the) return on common stocks will be close to the ROE of the business, absent any distributions and given a constant valuation. Let’s work through an example. Say a company’s stock is selling at $10 per share, book value is $5 per share, ROE is 20%, which means earnings will be a dollar and P/E is 10 and P/B of 2. If we add the $1 earning to book value, the new book value per share is $6, keeping the valuation constant and assuming no distributions, with 20% ROE, new earnings are $1.2 per share, stock at $12, up 20% from $10, which is consistent with the 20% ROE. This calculation is simple and not perfect, but it has been helpful in terms of thinking about returns on investment. So we spend our time trying to identify businesses which have above average returns on owner’s capital.” The restriction in Akre’s explanation is ” absent any distributions. ” In general, there are two sides of total return: the management side, and the investor side. Management can affect total return through ROIC, reinvestment, and acquisitions. Investors can affect total return through the price they pay and the return they can achieve on cash distributions. The Problem of Free Cash Flow Reinvestment into the business usually has the highest return (this post discusses only high quality businesses that have high ROIC). Problems arise when there’s free cash flow. Management must choose either to return cash to shareholders or to invest the cash themselves. Both options tend to have lower return than ROIC. Cash distributions don’t seem to give investors a great return. Stocks often trade above 10x earnings so distributions give lower than 10% yield. In my example, Commerce Bancshares wasn’t able to reinvest all of its earnings. It retained about 40% of earnings to support 5.6% growth and returned 60% of earnings in the form of dividends and share buyback. The stock usually trades at about a 15x P/E, which is equivalent to a 6.67% yield. The retained earnings had good return, but the cash distributions had low underlying yield. The average return was just about 10%. Unfortunately, many times returning cash to shareholders is the best choice. Hoarding cash without a true plan on using it destroys value. Expanding into an unrelated business for the sake of fully reinvesting doesn’t make sense. Similarly, acquisitions often don’t create a good return. The problem with acquisitions is that they’re usually made at a premium so the underlying yield is likely lower than the yield that would result from share buybacks. The lower underlying yield can be offset by either sales growth or cost synergies. Studies show that assumptions about cost synergies are quite reliable while sales growth usually fails to justify the acquisition premium. To illustrate this point,let’s take a look at 3 of the biggest marketing services providers: WPP, Omnicom, and Publicis. Omnicom is a cautious acquirer. It spends less and makes smaller acquisitions than peers. Its average acquisition size is about $25 million. Over the last 10 years, Omnicom spent only 16% of its cash flow in acquisitions while WPP and Publicis spent about 44% of their cash flow in acquisitions. Publicis is a stupid acquirer. It makes big acquisitions and usually pays 14-17x EBITDA. WPP is a smart acquirer. Like Omnicom, it prefers small acquisitions. When it did make big acquisitions, it paid a low P/S and took advantage of cost synergies. For example, it paid $1.75 billion or a 1.2x P/S ratio for Grey Global in 2005. That was a fair price as WPP was able to integrate Grey and achieve WPP’s normal EBIT margin of about 14%. To compare value creation of these companies over the last 15 years, I looked at return on retained earnings, a measure of how much intrinsic value per share growth created by each percent of retained earnings. As these advertising companies have stable margins, sales per share is a good measure of intrinsic value. Retained earnings in this case is cash used for acquisitions and share buyback, but not for dividends. As expected, Publicis created the least value: It’s interesting that the smart acquirer WPP didn’t create more value than Omnicom. That’s understandable because acquisitions aren’t always available at good prices. So, it’s very difficult for management to generate a great return on free cash flow. Therefore, the value of a high-ROIC business is limited by the capacity to reinvest organically. Free cash flow tends to drag down total return to low double-digit or single-digit return. The Investor Side of Total Return It’s very difficult to make a high-teen return by simply relying on management. The capacity to reinvest will dissipate over time and free cash flow will drag total return down to single digit. However, there are two ways investors can improve total return. First, investors can shrewdly invest cash distributions. When looking at capital allocation, I usually calculate the weighted average return. For example, if a company invests 1/3 of earnings in organic growth with 20% ROIC and 1/3 in acquisitions with 7% return on investment, and returns 1/3 to shareholders, how much is the total return? It depends on how well shareholders reinvest the money. If we shareholders can reinvest our dividends for a 15% return, the weighted average return is 20% * 1/3 + 7% * 1/3 + 15% * 1/3 = 14%. This number approximates the rate at which we and the management “together” can grow earnings (actually if payout rate is high, combined earnings growth will over time converge to our investment return on cash distributions.) Second, an investor can buy stocks at a low multiple. The benefit of buying at a low multiple is two-fold. It can help improve yield of earnings on the initial purchase price. It also creates chance of capital gains from selling at a higher multiple in the future. Warren Buffett managed to make 20% annual return for decades because he was able to buy great businesses at great prices and then profitably reinvest cash flow of these businesses. Small investors can mimic Buffett’s strategy as long as the stock they buy distributes all excess cash. They can reinvest dividends for a great return. In the case of share buybacks, they can take and reinvest the cash distribution by selling their shares proportionately to their ownership. That’s how Artal Group monetizes Weight Watchers (NYSE: WTW ). Share Repurchase at Whatever Price This discussion leads us to the topic of share repurchases. I think many investors overestimate the importance of share buyback timing. It’s nice if management buys back shares at 10x P/E instead of 20x P/E. But what if share prices are high for several years? Would investors want management to wait for years – effectively hoarding cash – to buy back stock at a low price? Good share buyback timing can help build a good record of EPS growth but EPS growth doesn’t tell everything about value creation. It’s just one side of total return. What investors do with cash distributions is as important. So, I think management should focus more on running and making wise investments in the business and care less about how to return excess cash. I would prefer them to repurchase shares at whatever price. By doing so, management effectively shares with investors some of the responsibilities to maximize total return. Share buyback gives investors more options. Investors must automatically pay tax on dividends but they can delay paying tax by not selling any shares at all. If they want to get some dividends, they can sell some shares and pay tax only on the capital gain from selling these shares instead of on the whole amount of dividends. Or they can simply sell all their shares and put all the proceeds into better investments if they think the stock is expensive. Conclusion I do not believe in buying a good business at a fair price. If the management does the right things, holding a good business at a fair price can give us 10% long-term return. But great investment returns require a good job of capital allocation on the investor’s part: buying at good prices and reinvesting cash distributions wisely.

7 Ways To Gauge Growth And Evaluate Value

Growth and value are cornerstones of fundamental analysis. Here we explore some of the most popular methods of gauging a company’s growth and a stock’s value. “Growth” and “value” are thought of as two very significant metrics in the world of fundamental analysis , two things that can cause a trader to buy, sell, or ignore. But what is growth? And what is value? These are words we hear and read every day, and that most people think they can easily define. You might think that a musician’s songwriting has grown, or you might give (or get) what you believe to be valuable advice. But in both of these instances, growth and value are subjective-matters of perception. But when it comes to the markets, growth and value are not so subjective. Rather, they are things that, for the most part, can be measured or weighed. Growth refers to a company’s performance, whereas value applies to its stock price. Moreover, there are very specific ways of gauging growth and value. Here we’ll discuss seven popular ways of doing just that. GROWTH: Past, Present, and Future. In simple terms, growth describes earnings. There are three different ways of looking at those earnings: past, present, and future. 1. The Past: Historical Growth As the common disclaimer goes, “past performance is not indicative of future results.” And as true as that may be, it doesn’t mean that it’s not good to know a company’s past. With that in mind, many traders and investors look at a company’s historical growth, which is really just a catchy way of describing the company’s annualized earnings in the past. When there exists a consistent increase in annualized earnings, there exists historical growth. 2. The Present: Free Cash Flow When it comes to measuring growth (or growth potential), some traders and investors like to follow the cash or, more specifically, the free cash flow. Free cash flow is, put simply, the difference between cash in and cash out. When there’s significantly more cash coming in, the free cash flow is strong. When the cash coming in is close to (or less than) the cash going out, the free cash flow is weak. Companies with strong free cash flow may have capital for R&D, acquisitions, etc. In other words, things that may very well help it grow. 3. The Future: Projected Growth If you’re going to look back, you may also want to look ahead. But where a company’s historical growth can be calculated by looking at their past performance data, a company’s projected growth is determined by analysts who look at a variety of information, including a company’s current and recent finances, as well as its stated objectives and outlooks. VALUE: Price Comparisons Growth places a heavy emphasis on, of course, growing. Value, however, does not. (After all, not every company aims to keep expanding, or even growing, its earnings. Some companies, whether they want to or not, just stay relatively consistent.) Value looks at the price of the company’s stock relative to the performance of the company, regardless of whether or not the performance is improving. Here are four popular ways of gauging the value of a stock. 1. Price to Earnings Ratio (P/E) This metric takes the stock’s price and compares it to the company’s earnings. It does that by dividing the stock price by the earnings per share (EPS). A “normal” P/E ratio is typically 20-25 times higher than the EPS. So a stock with a “normal” P/E ratio may be trading at $20/share, and have an EPS of $1/share. In this case, the P/E ratio is 20. Perhaps you can see where this is going: If a company is earning more money per share, but it’s not reflected in the stock price, the P/E ratio can be low (lower than 20), and this can suggest that a stock is undervalued (and thus, may be a good buy). For example, remember the example stock that was trading at $20? Now, let’s say its EPS is $5. The P/E ratio for that stock would be 4, which may suggest the stock price should go up to reach normal range. Or, consider the reverse: the stock is trading at $20, but the company is only earning $0.50/share. Now it has a P/E ratio of 40, which suggests the stock may be overvalued. 2. Price to Book Ratio (P/BV) To arrive at this measurement, you have to consider a hypothetical, which is to say, you have to know its book value. A company’s book value is the theoretical amount that every share would be worth if the company were to be completely liquidated. That number is then compared to the actual share price of the company. The result is the P/BV, or Price to Book Ratio. If the ratio is low (meaning the price is lower than the book value), the stock may be undervalued. 3. Price to Sales Ratio (P/S) How does a company make money? One major way is by selling, some in a traditional retail sense, and others in a more abstract sense (by selling its ideas or services). Regardless, since sales are often a significant source of money for a company, many traders and investors like to compare a company’s sales to its stock price. Here they do this by actually breaking down the sales to a per-share amount. With this figure, they formulate the Price to Sales Ratio. Like the above two ratios, a comparatively low stock price means a low ratio, which may be indicative of an undervalued stock. 4. Dividend Yield and Historical Rate of Dividend Growth Since dividends are cash payouts that companies pay their shareholders, dividends can be an important thing to many traders and investors. For one thing, dividends can allow a shareholder to earn income without actually selling the stock. And for another, the amount of dividends can be a good indicator of the health of the company. To take a deeper look, many users of fundamental analysis will look at a company’s dividend payment history. Consistent and increasing dividends may be a sign of a strong company, and a stock price that has not grown along with those dividends may be a sign of an undervalued stock. So, in the end, when you think about growth and value, think about these seven points. For growth, there’s the past, the present, and the future. And when it comes to value, do price comparisons-against earnings, against book value, against sales, and against dividend yields. Disclosures Schwab does not recommend the use of technical analysis as a sole means of investment research. The information here is for general informational purposes only and should not be considered an individualized recommendation or endorsement of any particular security, chart pattern or investment strategy. Past performance is no guarantee of future results. ©2015 Charles Schwab & Co., Inc. ( Member SIPC ) All rights reserved. (0614-4161)