Yesterday we had a Bristlemouth quiz and a number of clever bods nailed the answer: 15.9 times trailing earnings. If you got 15, you probably forgot to take the dividend forward one period. In the real world, you are close enough. The other assumptions, like a 15% return on equity for ever and a day, are going to be more wrong that the difference between 15 and 15.9 times earnings.
If you’re interested in the maths, go back and read some of the correct answers on yesterday’s blog (Erik Protzman’s answer is the clearest). If you prefer to think about things conceptually, here’s an explanation.
- Let’s say you pay $159 for a stock that last year earned $10 in profit (that’s the 15.9 times earnings). We know its dividend payout ratio was 60%, so the dividend must have been $6.
- Now the tricky bit. How much is that dividend going to grow? The company has kept $4 of profit and reinvested it in the business and it is expected to earn 15% (the return on equity) on that $4, or an additional $0.60 per share. So the earnings should grow from $10 last year to $10.60 this year and the dividend will grow from $6 to $6.36. This growth rate, 6%, will hold for as long as the company keeps the same payout ratio and keeps generating the same return on equity.
- Now for the total return. We paid $159 and expect to get $6.36 in dividends. That’s a 4% yield. And we get 6% growth per year, which gives us a total return on 10%, the exact return required in the question. Voila!
Armed with that, you should get a couple of marks on the CFA exam. But why is it important?
I often hear people say stock XYZ is trading on 10 times earnings AND it’s going to grow at 10% per annum. So what? This information is useless to you without knowing how much of the profit XYZ is keeping for itself.
If XYZ retains 100% of its earnings, you need it to grow at 10% per annum just to generate a 10% return. If it pays out all of its earnings as dividends and grows 10% per annum, you’re going to earn a 20% return. There is obviously a huge difference.
We need to keep this in mind when comparing, say, News Corp and Telstra. News Corp keeps a large chunk of shareholder profit every year and reinvests it back in the business. The payout ratio is low, the dividend yield is low and, as a consequence, most of your return has to come from capital appreciation. So, if News Corp reports a 6% increase in profit, you should view it as a mediocre result.
Telstra, on the other hand, pays out all of its earnings as dividends. You don’t need this business to grow when it’s yielding 10%. If they can stop it from shrinking (easier said than done), Telstra shareholders will do perfectly well from here without any earnings growth whatsoever. No profit growth for Telstra shareholders is better than 6% profit growth for News Corp, because News Corp is operating with an increased capital base every year.
That’s not to say one business is better than the other. Forced to throw my last $100 on one of the two, I’d go with News Corp. But growth means nothing without knowing how much extra capital has been used to generate it.
Ready to invest?
Visit this page for more information on how to invest with Forager.
Forager Funds is a boutique fund manager specialising in a value investing approach. We offer an ASX listed Australian Shares Fund as well as an International Shares Fund both aimed at delivering returns for long term investors.