At its core, investing is about generating the highest return possible for a given risk level. Equity investors generate return from 2 sources: dividends and capital appreciation. Capital appreciation comes from either multiple expansion from changes in the perception of a businesses’ future cash flows, or from real business growth.
Valuation Ratios, Perception, & Reality
Changes in perception of a businesses’ future cash flow potential do not reflect the actual underlying growth of a business. They are merely an expectation of what underlying growth will be in the future. We can’t know the cash flows of a business down the line, but we can guess. When analyzing the growth of a business, it is critical to adjust for expectation changes. Looking at stock prices alone distorts one’s view of the actual underlying growth of a business because expectation changes affect share prices.
Real business growth can be measured by a variety of metrics; growth in earnings, revenue, book value, assets, EBIT, or EBIDTA are all popular choices. The higher up one goes on the income statement, generally the more accurate the number for comparing businesses. Past revenue growth is a better predictor of future revenue growth than past earnings growth is at predicting future earnings growth. Unfortunately, unprofitable expansion can artificially inflate revenue numbers. EBITDA (earnings before interest, tax, depreciation and amortization) growth makes a strong proxy for overall business growth.
Capital Allocation & Enterprise Value
Management can finance growth organically with the company’s own cash flows, or through finance markets with debt or share issuances. Similarly, management can return money to shareholders by retiring debt or reducing share count. Lowering share count is obviously beneficial to shareholders as it increases the percentage of ownership of each shareholder. Reducing debt returns money to shareholders by eliminating debt holder claims on future cash flows.
Enterprise Value, Shareholder Return, & Debt
Imagine you were purchasing a business outright and you wanted to remove all claims other people have over the business. You would have to purchase all the equity of the business, plus retire all outstanding debts. As a bonus, you could take the cash in the bank account out of the business you purchased. Therefore, the enterprise value a business is equity value + outstanding debt - excess cash. When management retires debt, the company reduces its future obligations on cash flows, thereby increasing shareholders value.
The expectation/valuation multiple adjusted historical growth of a business is best measured by setting a constant valuation multiple to use for the EBITDA multiple. Setting a constant value has 2 advantages:
- It allows you to compare the business growth of any business on an apples-to-apples basis
- It accounts for changes in perception of the business that would otherwise distort growth measures
Standardizing Equity Value
EBITDA margins are about 1.9x net profit margins for the S&P500. The historical average P/E ratio of the S&P500 is about 15, and the historical average P/EBITDA ratio is a bit under 8. Using 8x as the standard EBITDA multiple to show business growth works well from a historical perspective.
Real Business Value per Share
The formula to estimate underlying business growth per share is the change in time of:
EBITDA per share x 8 – Total Debt per share + Cash per share
This formula takes into account share issuance/reduction, debt issuance/reduction, change in cash on hand, and business growth though valuation multiple adjusted EBITDA. Going forward, I will call this number the total real value per share, or RBV/S.
Dividends Matter to Shareholders
The only return item missing from the formula above is dividends. Dividend payments increase the growth rate of shareholders beyond underlying business growth. This is because shareholder return = capital appreciation + dividends. Underlying business growth (assuming no valuation multiple changes) creates capital gains; dividend payments are returns in excess of capital gains.
As with EBITDA, it is important to view dividend payments on a valuation adjusted basis so as not to penalize overvalued businesses and reward undervalued businesses. Do not confuse business valuation with business performance. One is the price we set on a business, while the other is how the business actually performs. Both are important, but analysis can become muddled when they are combined.
How to Calculate Shareholder Growth
To add in the affects of dividends, add the total amount of dividends paid per share over a time period to the ending RBV/S. Total valuation adjusted shareholder return growth for the period is:
( ( RBV/SNow + ∑D/S Now to Start ) / RBV/SStart )^( 1/time periods )-1
The shareholder return number above is a growth number. If the business behaves similarly in the future as in the past, shareholders can expect a return of close to the historical shareholder return.
Valuation Matters to Investors
Expected growth is only half the battle in investing. Valuation does matter. If you buy a business that can pay you 10% a year that grows at 8%, it is better than a business that can pay you 5% a year that grows at 8%. Therefore, businesses with lower valuation multiples are better than businesses with higher valuation multiples, all other things being equal.
The EBITDA/EV multiple has historically done a better job of identifying value stocks than other multiples. It is a good place to start when sorting businesses by valuation. Keep in mind, the EBITDA/EV multiple does not tell you the actual yield you will get when you buy a stock. It simply does a better job of sorting stocks by value than other valuation multiples.
Walmart & Amazon Compared
Armed with shareholder return growth (SRG) and the EBITDA/EV multiple, we can accurately sort stocks based on their historical growth and current valuation in an attempt to find cheap businesses growing quickly. As an example, we will compare the discount retail king Walmart (WMT) to the game changing e-commerce retailer Amazon (AMZN).
The 10 year numbers for Walmart are below:
Walmart has a 5 year compound growth rate of 10.46%, and a 10 year compound growth rate of 12.83%. Further, the company has an EBITDA/EV ratio of 12.38%, so it is not overly expensive.
Compare this to Amazon’s 10 year numbers:
Amazon has breathtakingly high 5 and 10 year compound growth rates of 28.48% and 21.10%. The company is extremely expensive right now, with an EBITDA/EV ratio of only 2.51%, about 5x as expensive as Walmart.
Assuming both of these businesses grow at their 5 year previous growth rates, it would take Amazon shareholders 18 years to catch up to Walmart shareholders EBITDA/EV yield.
This is assuming that Amazon retains its extremely high EBITDA/EV ratio, and grows at 21.10% for the next 18 years. I believe both assumptions are highly unlikely. Even in a very favorable scenario, an investor needs an 18 year horizon to rationalize investing in Amazon over Walmart.
Investors can shed light on how quickly a business is actually growing using RBV/S growth and dividend payments. Investors can easily compare how expensive a business is in relation to other businesses using the EBITDA/EV ratio. Calculating how many years one business must grow before it passes another business can give you an idea of what investment best fits your time frame.
It is important to note that the Amazon to Walmart comparison did not adjust either businesses growth rates down over time. Amazon has a bright future, but it is highly unlikely the company can grow shareholder value at 20% per year for the next 18 years. It is also highly unlikely that Amazon will trade at such a high EBITDA/EV ratio in the distant future like it does today. Correcting for these two factors would show Amazon investors would have to wait significantly longer than 18 years to catch up with Walmart investors.