This is one of those inside-baseball questions that the serious, more-than-part-time investors out there will probably enjoy.
Hi, Joshua. I could read your blog all day. Thanks for everything that you do.
When I read your commentary on payout ratios, it seems to focus on EPS payout ratio, or dividend coverage. I don’t understand why you don’t focus on free cash flow, instead. As a corporate accountant, I know how easily EPS can be fabricated or adjusted to be almost any amount. EPS, a GAAP reporting concept, does not pay dividends, but free cash does. Can you please provide either a response or a post addressing this? Thank you, again.
You’re absolutely right on your insistence to use a cash flow based metric in the ability to fund dividend payouts (as well, I should add, as it being the appropriate starting point for the calculation of intrinsic value). I use a modified form of what has been dubbed “owner earnings” that attempts to approximate cash flow on the base business, stripped of any leverage effects, and distortions caused by growth. It’s derived from the old calculations that became popular back with the rise of finance as a serious discipline, with a lot of the credit going to the folks at DuPont, who really took enterprise analysis to a new level.
You see some form of this referenced all the time; if I recall correctly, I think even the media’s favorite investor, Warren Buffett, discussed using it as his investment partnerships when he was interviewed by Adam Smith back in the 1970’s after he had closed the doors and focused on his new holding company. Being a corporate accountant, you’ll understand my reasons for preferring it (for those who aren’t, it’s because it immediately tells me the utility I could receive in the form of cash that can be extracted and spent, given to charity, saved, or reinvested were I in total control. Not only does it provide a rough gauge for the utility of ownership, it also puts all assets on equal footing, so it doesn’t matter if I am valuing a hotel in my hometown or a share of common stock for a brokerage account – it’s all about collecting the most, net, risk-adjusted cash relative to what I have to spend to acquire the right to the cash stream).
An adjusted cash flow metric is a much better figure, for those who can read financial statements fluently, than reported earnings per share, both when it comes to determining the stability of a dividend and the true nature of the corporation or partnership. An illustration: Many years ago, I remember reading the UPS annual report and discovering that the year-over-year increase in reported diluted EPS was mostly the result of a change in the way management paid its executives, taking advantage of the accounting treatment of a certain type of arrangement. It’s been a long time, but I think they also changed the discount rate used to value the pension liabilities, and some other small adjustments. UPS is a great business with a very strong franchise, and I imagine they were doing it so they could keep the charts in their annual report in a nice, upward slope, marching ever higher, but I ended up using a lower figure to value the firm and, as a result, didn’t buy the shares. I wrote about it back in 2006. In fact, it made me somewhat dubious as to whether or not I could trust management’s public assessment of the company as they weren’t exactly forthright about the underlying cause of the increase, but rather touted it as something that had to do with their superior abilities.
My Preferred Cash Flow Calculation for Determining Intrinsic Value and Dividend Coverage
I make a few modifications for my own personality and the sake of conservatism, but the basic formula is this:
Reported Net Income
+ Depreciation and Amortization
+/- LIFO Inventory Reserve Adjustments
+/- Accounting Adjustments That Obfuscate Reality
+ Required Working Capital
– Maintenance Capital Expenditures to Maintain Current Unit Output
+/- Adjustment Factor for Overfunded or Underfunded Pension
+/- Adjustment Factor for Other Non-Avoidable Contingent Cash Inflows or Outflows
= Stable Cash Extraction Value for an Owner Opting for a 100% Dividend Policy of Any Earnings Not Required to Maintain Current Competitive Position in the Industry
Then I compare that value, if I could own the entire enterprise, lock, stock, and barrel, to the net capital required to be invested in the business, both equity and total, as a mechanism for determining the quality of the firm’s existing operations, factoring in things like durable consumer brands that would be almost impossible to displace or physical advantages that competitors can’t replicate (e.g., possession of a key oil field, a cement company being mostly local, etc.), or a hidden asset that makes the numbers somewhat inconsequential (e.g., if you were buying a farm on top of a natural gas well that no one knew existed, it would be somewhat foolish to value solely the cash flows from the corn and wheat, without factoring it what you are going to get from the energy asset that you can monetize) which is the art part of it.
Owner Earnings, or Cash Flow, Is a Much Better Figure Than Reported Earnings Per Share
At that point, were I satisfied with the type of business, I would then look at the capitalization structure, and any potential dilution from stock options, outstanding warrants, convertible securities, or other source, and calculate the worst-case per-share stable cash extraction value. I would then value the company and determine the various return ranges most probable given a cost outlay today at a given price. For the sake of conservatism, I opt for the most senior security in the hierarchy with the greatest potential maximum theoretical payoff (e.g., it’s rare, but during a crash, you might get into a situation where some small bank out in California is a steal, but you can get convertible preferred shares yielding 15% dividends with a lottery ticket attached in the form of the common stock – this sort of thing happened in 2008-2009 when there were mass liquidations taking place, and sometimes lasted only a few days or weeks).
[mainbodyad]As for future growth plans, I tend to look at management’s track record and ability to put retained money to work at rates of return at least equal to those generated by the existing businesses. If I’m satisfied, I’ll use that information, look out 5+ years, and attempt to come up with a conservative range for where I think earnings and dividends will be. My task is then to make sure my family’s collection of assets is one that is not only safe in the long-run (short-term volatility doesn’t enter into the equation as I avoid debt and derivatives for the most part, giving me the freedom to wait out unfavorable conditions for years), but likely to produce the greatest net earnings and dividends 60 months from today. What makes it a bit more difficult than it sounds is trying to account for the leveraging effect of deferred taxes; you can’t just switch from an investment that looks like it will be earning 8% to one earning 10% because you may end up in a worse position after accounting for your reduced capital net of taxes, transaction fees, and other considerations.
Why I Use Reported Earnings Per Share Instead of Cash Flow In My Illustrations
Why, then, do I use reported EPS instead of the adjusted cash flow figures when illustrating concepts?
- It’s faster
- It’s less scary to a new investor. I’m trying to ease them into thinking of stocks like real businesses and you can use it as a sort of rough proxy without having an advanced knowledge of GAAP.
- It lets me focus on whatever it is I am trying to explain without a lot of distractions (e.g., walking through the opportunity cost differences between PepsiCo and Wells Fargo awhile ago let me talk about opportunity cost, not whether or not I think the development in the loan book is going better or worse than expected, or whether I agree with the depreciation schedules of the new bottling plant in India or something).
- Generally speaking, a broadly diversified collection of assets based on reported EPS should still perform in a correlated way with the underlying owner earnings calculation. If you have a portfolio of 30 stocks, it’s probable that one company depreciating too slowly over here is going to be made up by another firm underestimating the future rate of return on some other project over there.
Dividend Track Records Can Be Used as a Sort of Layman’s Guide to Cash Flow or Owner Earnings
For someone who doesn’t want to bother with learning advanced accounting, there is sort of a cheap and dirty backdoor hack that can do most of the heavy lifting. As the saying goes, you can’t fake cash. When a company pays a dividend, the money is either deposited in your account or it’s not, and once it’s yours, it’s yours. It acts as a sort of rebate on the purchase price.
[mainbodyad]If a firm has a long track record of rising dividends, far in excess of the rate of inflation, and you instinctively know that the brand has staying power (e.g., Clorox or Coca-Cola), you can look at the long-term historical range of dividend yields, and only buy when the dividend yield is in the top quartile compared to its long-term record. It’s not a perfect approach, but taken on a whole, it has some merit as the net effect is often to replicate the same sort of owner earning calculation you would get if you had the skill to perform an advanced analysis. You also have to make sure that the dividend payout ratios aren’t climbing higher.
For example, if Coca-Cola were yielding 4%, and the dividend payout were 50%, based upon a century of analysis, in almost all circumstances short of some unknown variable for which we are not presently accounting, it’s got a much better than average chance of turning out to be a fantastic long-term holding.
There is actually a niche approach to investing that follows this line of reasoning (and has performed quite well, historically), based on a tome penned more than quarter-of-a-century ago called Dividends Don’t Lie. It has recently been updated in a new book called Dividends Still Don’t Lie. It’s actually shocking how closely the valuation figures produced by their relatively simple methodology end up matching my own. The only downside of the approach is it doesn’t permit you to take advantage of some great opportunities, such as if you saw Chipotle in the early days rolling out across the country or Apple when Steve Jobs returned. Still, that’s fine. In investing, it’s not so much the wins that matter as it is avoiding losses. Compounding can perform miracles if you just avoid permanent losses of capital. For the regular investor, I think this is a safer, more intelligent way to behave, even if it means passing on some businesses you might otherwise buy.