One of you, writing under the name Emma, posed a question in the comments section of another post. You asked me whether or not I thought a firm like Coca-Cola could repeat its historical performance. Rather than answer the question directly, I realized this would be a great opportunity to explain the variables that drive results. If you’re experienced, this is all axiomatic, but for those of you who are completely new to the game of putting money to work, it can be a useful overview.
Since the question involved Coke, I’ll use it, but we could really substitute any firm since we’re discussing the more abstract forces that determine how rich one gets from holding an asset. Shares of The Coca-Cola Company have historically compounded at between 9% and 10% per annum over very long periods of time but there are interludes of wide variation in there (that’s the cost of equity ownership; it’s the nature of the asset). For example, you see 50%+ drops in periods like 1973-1974 or the sugar crisis around 1920. In theory, all assets fluctuate in value like this, only some (e.g,. cash generating apartment buildings, privately held mortgages on residential properties, or stakes in a family-controlled operating company) have no regularly quoted market value so the psychological effect is for investors to believe these assets are somehow more inherently stable. That’s another conversation for another day.
Let’s break down each of the factors one at a time. What, specifically, drives investment profits?
1. The Base Earnings Yield and Dividend Yield
The starting earnings yield and dividend yield are the foundation of return. For Coca-Cola this year, final results should come in so that the base earnings yield figure is 5.33%. This is the amount that, if the company never grew and paid out 100% of its profits in cash, you’d collect regardless of what happened in the stock market.
Of course, the company wants to grow so doesn’t pay out all of its profits. It holds some back for management to use to fund expansion. At the moment, 3.06% ($1.12) of the 5.33% ($2.09) is distributed in the form of cash dividends, with the other 2.27% ($0.97) plowed back into the business or used for share repurchases.
2. The Growth In Diluted Earnings Per Share
Simple enough so far, right? If Coke could just keep doing what it does, earn the same returns on capital, maintained the same dividend payout, and sat, ignored, for 25 years, we’d collect 5.33% on our initial investment at today’s price. That means to get to our 9% to 10% historical return, that other 3.67% to 4.67% has to come from somewhere.
The “somewhere” is the growth in the diluted earnings per share, which is influenced by many different factors, including:
- Coke’s ability to increase its syrup concentrate price at a rate equal to or greater than inflation,
- The number of eight-ounce servings consumed on the planet per capita,
- The total population growth in Coke’s markets as more people are born each year,
- Any new product launches or acquisitions that expand beyond the existing business (e.g., Pepsi now generates more than half its money from Lay’s potato chips, Quaker Oats oatmeal, etc.)
- The rate of corporate taxation on earnings
- Efficiency gains in manufacturing and distribution
- The interest expense paid on debt
Combined, these factors need to produce the other 3.67% to 4.67% in annual increase we need on top of the 5.33% base earnings yield to produce our 9%-10% annual growth rate.
3. Change In the Valuation Multiple Applied to Every $1.00 of Profits
The final determinant of our return is the multiple investors are willing to pay for every dollar of profits. For example, if a company earned $1 and you paid $10 for it, you were valuing it at 10x earnings. Without growth, this would lead to a 10% return. This multiple is known as the price-to-earnings ratio and it depends upon two main factors:
- The projected growth rate in future earnings (higher growth means a higher multiple because you can pay more and still do well)
- The interest rate on long-term low-risk bonds (when bond yields are high due to high interest rates, bonds become more attractive relative to stocks so investors refuse to buy stocks unless they provide a fatter dividend yield to compete, which means the share price must decline; hence a lower multiple. The opposite is also true.).
To go back to our Coca-Cola example, this year, Coke is expected to earn $2.09 per share. The company is trading at $39.30 pre share. That means for every $1.00 in after-tax corporate profit, investors are willing to pay $18.80, or an 18.8x multiple.
Why does this matter? Let’s imagine for a moment that Coke grows its earnings at 7% for the next 25 years (there is no guarantee it will, I’m just pulling a number out of a hat to illustrate the concept we are discussing). Further, let’s assume it holds it dividend payout ratio steady so dividends increase in direct proportion to profits. A quick back-of-the-envelop calculation tells us that over the next quarter-century, each share of Coke would deliver $132.19 in net income. Of this, $70.84 was paid out in cash dividends and $61.35 was retained by management. In the final year, diluted earnings per share would be $11.34.
What is the stock price? It depends on the multiple applied to that $11.34. If the same 18.8x rate applied that is in effect today, the stock would trade at $213.19, plus you’d have your $70.84 in cash dividends, meaning you turned an initial investment of $39.30 per share into $284.03. That’s a compound annual growth rate of 8.2%.
Imagine interest rates had skyrocketed, Coke’s prospects dimmed, and investors were only willing to pay a multiple of 10x profits. In this case, the share price would be $113.40 in the final year, plus you’d have collected $70.84 in cash dividends for a total of $184.24, or a compound annual growth rate equal to 6.4%.
If You Plan on Selling, That Last One Is Going To Exert an Influence On Your Returns Like Gravity Does to Matter
That is amazing, isn’t it? The exact same profit growth. The exact same cash dividends. Yet, in one scenario you ended up with 8.2% compounded and in another 6.4%. Your final wealth would be significantly different; $284.03 versus $184.24.
Yet, here is the important point: The influence of the valuation multiple in the final year only matters if you plan on selling in that final year. In both scenarios, you still received cash dividends of $70.84 to date. In both scenarios, your annual dividend income in the final year is $6.08. If you don’t need the money from the stock itself, you can live off those cash dividends and continue to hold, taking advantage of deferred taxes. There will have been no practical effect on your day-to-day life, either for good or bad, in either situation. In both scenarios, you could have juiced your return a percentage point or two by plowing the dividend back into more shares, reinvesting it so the dividends were generating dividends of their own. (Again, we didn’t assume that in this discussion, but it’s a possibility for the investor.)
Valuation multiples swing from depressingly low to stupidly high. It’s just how the world works. To be upset because the multiple happened to be low at a particular moment isn’t a very intelligent way to behave as long as your initial purchase price was good. Likewise, to be euphoric because the multiple skyrocketed isn’t particularly wise unless you plan on selling. Look at Coca-Cola in the late 1990’s. People were lauding management, talking about the wealth it was creating – and they were – but a huge part of that was due to an expanding multiple, which is my least favorite way to make money. The opposite is also true, with people wrongly criticizing Microsoft for its stock performance the past ten years. The software maker has knocked it out of the park in terms of earnings, but the shares were valued so highly at the turn of the millennium the multiple had to come back down to Earth.
(On a side note, this is why professionals often advocate the inexperienced opt for a strategy known as dollar cost averaging. It averages out the prices paid for a particular stock or mutual fund, lowering the chances of getting crushed by falling on the wrong side of this phenomenon.)
The Summary Answer to the Question
All of this is to say, in answer to your question: It depends. It depends on that initial base earnings yield / dividend yield you collect, the subsequent growth in the earnings and dividends thereafter, whether or not your reinvested your dividends (including if you hold them in a tax-shelter such as an IRA, which will improve your performance), and the ending valuation multiple applied to final-year net income. My thesis is that, yes, someone who was regularly buying for a 25-50 year time period, treating a firm like Coke as a permanent holding, would be able to capture the mean valuation, so they’d come close to hitting the historical returns due to the underlying strength of the economic engine. The reasons they may not are legion – the most evident of which would be an inability to watch a position fall by 50% or 75% during some economic meltdown, even when the company itself is fine, or the tendency to want to find something more exciting to do with the money, causing all sorts of frictional expenses.
If you go through life picking up stuff like this, though, you tilt the odds in your favor so good things tend to happen. You never know where to expect them, and you can never predict with any degree of accuracy the timing or amount, but that’s part of the magic.