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).
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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.