GuruFocus Premium Membership

Serving Intelligent Investors since 2004. Only 96 cents a day.

Free Trial

Free 7-day Trial
All Articles and Columns »

Michael Mauboussin - Frequently Asked Questions About Buybacks and Dividends

May 19, 2014 | About:
CanadianValue

Canadian Value

114 followers

Introduction

The value of a stock equals the present value of future cash flows. Sooner or later, an investor in a stock must be able to put cash into his or her pocket for a stock to be of value. Ultimately, a company’s value boils down to the cash it can disburse during its life.

There are three ways a company can transfer cash to its shareholders. First, the company can sell itself for cash. In a cash sale, the acquirer has to worry about generating sufficient cash flows to justify the price, but outgoing shareholders can take the money to the bank. Second, a company can pay a dividend. A dividend is a distribution to shareholders that generally comes from profits. Finally, a company can buy back its shares.

Similar to dividends, buybacks distribute cash to shareholders. But unlike dividends, only shareholders who sell can cash in.

The topic of how best to return cash to shareholders, especially through dividends and buybacks, is always relevant but is especially so in today’s environment. To see why, consider this simple but foundational equation:

Earnings Growth = Return on Equity * (1 – Payout Ratio)

This says, in plain words, that a company’s growth rate is a function of how much it makes on its investments (which the return on equity, or ROE, determines) and how much it invests (which the payout ratio dictates, with a low payout ratio meaning high reinvestment).

Companies with higher ROEs can grow faster than companies with lower ROEs given the same payout ratio. Likewise, companies with lower payout ratios can grow faster than companies with higher payout ratios given the same ROE.

Let’s put some numbers to work to make the point. Assume a company has an ROE of 20 percent ($200 of earnings divided by $1,000 of equity), pays out 50 percent of its earnings ($100), and retains 50 percent of its earnings ($100). The company should be able to grow earnings in the next year at the rate of 10 percent, or from $200 to $220 (a 20 percent return on $1,100 of equity). This is consistent with the equation (10% =
20% * [1 - .50]).

More accurately, the earnings growth in the equation is the maximum growth rate the company can achieve excluding external financing. If the growth in earnings is less than what the product of the ROE and payout ratio suggests, the company will generate excess cash. Say earnings growth is five percent. This means the company could have paid out 75 percent of its earnings, or $150. But since it only paid out $100, the
company generated $50 in excess cash.

This formulation is the key to understanding today’s situation. In a nutshell, return on capital is high, payout ratios are average, and growth is low. As a result, companies are generating prodigious excess cash.

Here is a look at the components. Exhibit 1 shows that asset-weighted cash flow return on investment (CFROI®) for corporate America, currently above 10 percent, is at an all-time high. CFROI is a measure of the cash return on the investments a company makes. As the figure is adjusted for inflation, it is comparable through time.

Continue reading here

About the author:

Canadian Value
http://valueinvestorcanada.blogspot.com/

Rating: 5.0/5 (4 votes)

Voters:

Comments

mungerman
Mungerman - 4 months ago

I admit I'm not very astute when it comes to investing, but I don't ever remember receiving cash from a company when it repurchased shares. Why then, is a stock buyback a transfer of cash to me, a remaining stockholder? I have seen many companies repurchasing shares and the price of the stock has declined. Isn't it quite difficult to say that I received a dollar of value for each dollar the company spent on buying back stock? There is no additional cash in my pocket.

vgm
Vgm - 4 months ago

Mungerman -- if a company is buying in its own stock at at price below its intrinsic value, then each remaining share you own becomes more valuable over time as the price rises to meet intrinsic value. You actually want the stock price to languish while buybacks are happening. Buffett discussed this in detail starting page 6 of the 2011 AR:

http://www.berkshirehathaway.com/2011ar/2011ar.pdf

Please leave your comment:


Get WordPress Plugins for easy affiliate links on Stock Tickers and Guru Names | Earn affiliate commissions by embedding GuruFocus Charts
GuruFocus Affiliate Program: Earn up to $400 per referral. ( Learn More)
Free 7-day Trial
FEEDBACK