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.
[mainbodyad]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.)
[mainbodyad]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.
Reader Comments (11)
Comments are presented chronologically, with replies indented beneath the comments to which they respond.
Jason
December 18, 2013
Test… did I just comment? Maybe it's awaiting moderation. If my first comment is awaiting moderation please just delete this comment
David
December 18, 2013
Joshua, I've heard warren say that you cannot compensate for risk with a higher discount rate. Was he referring to cat- risk type investments? Because it seems like margin of safety and a higher discount rate can be both different to come up with the same intrinsic value... Why does it matter if you think you are getting a higher discount rate with a lower margin of safety than if you have a higher margin of safety with a lower discount rate? Hopefully that makes sense, it just seems like an issue of semantics to get to the same intrinsic value, but maybe I'm thinking about it wrong. - Maybe it has to do with Warren's idea about only investing in companies with bond like earnings characteristics?
Joshua Kennon
December 18, 2013
Replying to David
This is a debate that comes up from time to time in various money management circles.
Personally, I think of it this way: If the intrinsic value of an asset (car wash, common stock, private business, bond - whatever) is based upon discounted cash flows relative to the risk-free rate, then trying to compensate for the inability to predict those cash flows by using a higher discount rate causes one to think they are investing when they are, de facto, speculating because the single most important input - the cash flows - are too uncertain to matter. So you get this odd precision when precision isn't possible.
Approaching it this way means you either reject out-of-hand opportunities that appear like investments but aren't, or you accept that they are speculations and only commit funds in your separate, speculative account to them as a sort of lottery ticket that you try to acquire intelligently through a margin-of-safety approach. (Which you may still decide to do. I have a few positions that fall into this category and you can make money if you're good at it.)
It's not so much the math that's different - as you point out, it can lead to the same outcomes - but a world view that helps insulate you against self-delusion; from thinking you're investing when you're not. (Investing, in this case, being defined as Ben Graham used it: An operation that promises with a high degree of certainty both safety of principal and a satisfactory return.)
David
December 18, 2013
Replying to Joshua Kennon
So, would you say that a car wash is a speculative investment . Say for example, that the industry average multiple of pretax earnings for car washes is 5x, then it would seem that this is the market pricing in the perceived risk and time vs a treasury bond at 30x (and liquidity premium). Of course, the interesting thing that I've been thinking about lately is in regards to inefficient markets for private businesses.
I used to think wow, look at how cheap this is, look at how easy it would be to compound money at 25%. But of course, there is a reason for this and it is the inability to have certainty with regards to the cashflows and whether or not you can operate effectively. Maybe the private business market is not so inefficient afterall. The extra variable, that seems to be the most important aspect, is who is buying the business or asset. Assets that have a fairly decent active role requirement seem to have the greatest ability to compensate for this risk.
So, my question to you is, do you think buying a car wash is an investment or speculative? Is it an investment only if you are a skilled operator?
How much speculation was present in buying sees candies? I believe warren paid 5-6x pretax earnings. It seems he must have thought this was more speculative than a bond. But, does being more speculative still mean it is an investment, just less safe?
And, in regards to predicting cashflows effectively - say for a car wash, what exactly would give you 'certainty' enough to qualify it as an investment (i.e. 5 years of stable earnings history with inflation growth?) - and being a decent operator?
Thanks for your insights
Joshua Kennon
December 18, 2013
Replying to David
I think you head the nail on the head - a private company could very well be either a speculation or an investment based entirely upon the operator making the acquisition because the skill set, experience, connections, or other assets he or she brings to the table influences the stability, predictability, and level of cash flows in a significant way. Even something as simple as being friends with the bank president, who will underwrite a cheap loan, lowering the cost of capital, matters.
Private businesses tend to trade at much smaller multiples for a myriad of reasons, the biggest of which is the "nuisance" factor. If you buy a $500,000 block of Coca-Cola, you might be getting an earnings yield of $25,000 growing at 7% to 10% over long periods of time with dividends reinvested but you don't have to a damn thing to it other than read the 10K once a year and make sure things are humming along nicely. You can go about your life as the money comes in, year after year, and the dividends grow.
If you use that same $500,000 to buy a local business that is in trouble, you might very well be able to turn it into a $250,000 annual income, all in cash, because you are good at your job or you spot an opportunity others miss. On the flip side, it's easier to lose the money or even go bankrupt.
When it came to See's Candy, I don't think there was any speculation at all. The company was bought based on relatively stable historical earnings patterns that were well established in the candy industry over a very long time, there was professional management in place, the brand equity had enormous cache in a certain geographic area of the country, and Buffett had deep enough pockets that, if necessary, he could have changed management teams.
For a car wash or something like that, I'd look at the tangible assets included in the deal (e.g., even if profits are $0 but you can sell the underlying real estate for $x amount with a high degree of certainty, that matters). Then, I'd figure out what it should be earning based on the geographic location, capacity, cost structure, and hundreds of other variables, valuing it on that - not just what the past owner had experienced. Why? It's different than a stock. I'm the guy in control. I can pull the levers and make money, whereas my ability for a stockholder to influence Coke's earnings is nill. (I would not, however, pay up to the old owner for those higher earnings figures because I'm not going to compensate them for their failures. Any offer I made would be based on the business as is).
In other words, for a private business, I'd be running all sorts of spreadsheets - total cars that pass by per hour, ranges of "bad", "okay", and "great" car washes as a ratio of that pass-by rate, car wash bays per capita in the area, etc. Those would be my guiding figures, and what I could do with them, not the existing earnings pattern. But that's because I'm me - I'd be the operator. That's what I mean when I say someone who is a skilled operator can do very well in life if they put their talents to work. It's a rare thing requiring attention to detail and strategic thinking.
poor.ass.millionaire
December 19, 2013
Replying to Joshua Kennon
Hey Joshua, I'm going to jump in this convo because I think that owning/investing in small businesses is a closer analogy to active real estate investing than the stock market. I also appreciate your detailed answer about risks and returns in owning blue chip stocks long term on the other thread.
Where RE and blue chip intersect, at least for me and my market, is that certain quality real estate can become blue chip in nature. This may or may not be possible with small companies, but I suspect usually not as normally they are: regional/local, not based on strong patent protection, have lots of similar competition. OTOH real estate in highly desirable yet very limited markets can have a safety margin akin to blue chip, even for small properties. This is probably even the case in your own local market. I'm sure there are very desirable neighborhoods that cannot easily expand, are highly desirable, and available homes for sale are limited. Of course you need other factors like strong job growth/base, and inability to simply add new "highly desirable" subdivisions nearby to compete. We have had that situation in the Bay Area, and especially in San Francisco for over 20 years. The massive tech industry and almost no growth (being surrounded by water on 3 sides) have been major contributing factors.
So when you have these situations, your RE investments can become quite stable and safe for the long term, like blue chip stocks. But you normally have to already be in the market, because starting out from scratch requires substantial money, as you won't cash flow with a small down payment. So the active market mostly consists of players that have already built significant asset bases. These investors have the ability to leverage their equity in existing properties to buy new ones. In reflection, I'd have to say that the huge equity gains, and the ability to leverage them have been the two biggest contributors towards my ability to build wealth. You can also add wealthy foreign buys (usually Asian in SF's case), but they are buying more as safe havens for wealth made elsewhere (Chinese sweatshop, anyone?)- and they tend to buy nice condos in downtown high raises and pay all cash. Additionally, some tech entrepreneurs dip their toe in the RE investment market; but usually they just add to the demand for nice homes.
Other than that I think a lot of the principals you discuss above pertain to active RE investing; turning a property around to highest and best use, efficient selection and management of tenants, etc. OTOH I see my RE management affairs as pretty much hands off. I know how to work with tenants so my turn over is low. My properties are all in good condition, and I have repair guys to send out if needed. Matter of fact, for fun I've learned to fix a few things myself. Funny how it takes me 4x as long as a pro, but it's kind of a hobby every now and then. But the real fun part is being able to leverage existing property and look for new projects.
Like small businesses, where you invest and your worldview are huge factors. I know so many people (online) that invest in cash flow markets or in the boom and bust markets like Arizona, Florida, Vegas, etc. While I'm sure you can do well, most of those people are still "trying to make it" (achieve financial independence.) OTOH I know numerous investors in the Bay Area that have already "made it." So real estate is extremely local; I know how to make money in my market, but wouldn't touch other areas.
My parting words for budding investors is: learn the specific details of your market, operation, strategy inside and out. Be specific in how and why you can do something better than most. And leverage that knowledge to expand your holdings. Better to be concentrated and successful at first, than later think about diversification. At least with small business and real estate investing.
Richard Garand
December 19, 2013
Replying to David
A large part of the reason private businesses have lower valuations is that you can't just buy it and walk away. Even if you hire managers or have a very simple business like a car wash there will be times when you, as the owner, have to perform time-sensitive tasks or risk losing the business. Small service businesses that get their competitive advantage from the experience of those doing the work have virtually no value once the current owner leaves. Conversely you can compete with them just by going out and talking to potential clients rather than buying the business, which also diminishes the value in a sale (a low replacement cost).
A shareholder in a publicly traded company never faces that. The higher return on private businesses is in part a payment for your time and skill. Apart from deciding whether the payment is sufficient, you also need to decide if you want to buy yourself a job along with your investment.
Connelly Barnes
November 5, 2014
Replying to David
Interesting.
I always thought Graham meant at the portfolio level that an investment operation needed to promise safety of principal and an adequate rate of return. Otherwise his net-net buys of companies like steel, aviation, automobiles, and wood at Graham-Newman would have to be considered speculative!
I also liked Keynes' definition: "appropriate the term speculation for the activity of forecasting the psychology of the market, and the term enterprise for the activity of forecasting the prospective yield of assets over their whole life."
Typically I don't care about anything except the margin of safety, and how long it will take before the market price meets the intrinsic value. But I think there's wisdom in owning a lot of positions that would not be negatively impacted by Great Depression type scenarios. I should learn more about that.
Dan
December 19, 2013
Joshua, a great read, thanks.
You provide great insight as to your valuations for stocks that pay dividends as well as make profits. My question has to do with stocks that do neither, or do so on a fluctuating basis. I would guess that you personally have no investments in a stock like AMD at this time. They are a well known company with real sales and 10,000 people employed. They must be worth something, but how can a company as such have a "rational" price calculated for it?
Joshua Kennon
January 8, 2014
Replying to Dan
You would be correct that I don't own investments like that. I think there is probably a rational price for it, and people with experience in that field. I, for example, may not particularly like the sporting goods business but given my background, I would be able to tell if a sporting goods store were selling for super cheap. At some point, the margin of safety justifies a purchase.
Stanley
July 9, 2014
Hi Joshua,
I'd like to ask if there is any way to quantify return on retained earning? In reference to your article here: http://beginnersinvest.about.com/od/analyzingabalancesheet/a/retained-earnings.htm
I've read about RORE, whereby Normalized Earning for the Period / Retained Earning (Previous Period) = RORE
But that is not taking into account that Revenue is driven by other factors as well, for example debt. Or am I just thinking too much, and that RORE is sufficient to measure management's ability to put retain earning to use?
Once again, thank you for those articles you have written - I find them more accessible and easier to understand than diving straight to a finance textbook.