Someone who uses ValueLine asked me this question:
“I understand that the ‘Line’ on Value Line reports is essentially a regression to the mean valuation. If we assume that the market is rational when averaged over time, the line is a reasonable valuation. This leads to an interesting result. If these are the average values investors are buying at over time, doesn’t that mean there is a huge premium put on the stability/dividend of (stock like) Nestle (XSWX:NESN, Financial)?”
You’re right that what ValueLine is doing is betting on a regression to the historical mean. It’s saying that you should buy a stock at less than the average price to some multiple that some company has traded for in the past. There’s a problem with this. Some stocks consistently outperform other stocks – not by a little but by a lot. A stock like John Wiley (JW.A, Financial) returned something like 13% per year over 30 years at some point where the market returned something like 9%. The same would be true of a stock like Omnicom (OMC, Financial). It also returned a couple percent per year better than the market for decades. This is a huge difference. The reason it happens is the market isn’t quite as rational over long time periods as a pure mean regression would suggest.
Let’s talk about what “fair value” would be for a stock. Now, we can answer this question in theoretical terms quite easily. Warren Buffett has talked about John Burr Williams' “The Theory of Investment Value” and the definition that book has for the value of investment. Basically, the idea is you take all the future cash flows from a stock and then you discount it back to today. That’s a DCF. And that’s theoretically what a stock is worth.
But DCFs are too tricky to do. They are impractical. You do them in business school. I have seen investors talk about them – even value investors. But doing a DCF just isn’t worth your time. The range of assumptions included in the DCF are so great that you can finagle things to get whatever answer you want. It’s like a corporate IRR estimate that way. The people preparing the rate of return estimate for the chief financial officer or whoever know whether top management wants to open this plant, acquire this company, etc. The projections aren’t worth much. The math involved in a DCF is very sensitive to assumptions ranging from the growth rate to the discount rate, and both the growth rate and the discount rate are very discretionary.
For example, I just did a report on Bank of Hawaii (BOH, Financial). Historically, that bank had grown deposits per share at something like 5% to 6% per year over the last 15 years or so. I think we picked 3% as our assumption. Do you know how big the difference in terminal value you’d get from adjusting a historical – let’s say 5.3% – rate of growth in deposits down to 3%? It’s a huge difference. One, you have the base line 2.3% per year difference in value right off the bat. That’s the difference between a stock returning say 8% per year and 10.3% per year. If you can beat the market by 2.3% per year for decades, you can have quite the career in investing. This adjustment alone is big just in terms of first order effects.
But what about the secondary effects? Bank of Hawaii isn’t going to open more branches. It already has enough. It covers the state of Hawaii. It is the No. 1 or No. 2 bank in like five out of every six ZIP codes on the island. Mobile banking is growing. Traffic to each branch is down a lot in the U.S. Banks will never again need to have as many branches as they do now. Bank of Hawaii can grow its deposits without ever growing its branches. I don’t expect the bank to ever open another net branch in a year. It might open one branch. But it’ll close another branch in that same year. Ten years from now, Bank of Hawaii will not have more branches than it does today.
When we ask will it grow deposits by 3% per year or 5.3% per year for the next 10 years – what we’re asking is will it grow deposits per branch by 3% per year or 5.3% per year? If the bank grows deposits by just 3% per year, we’re talking the rate of inflation. Branch expenses like rent and labor will go up at 3% per year. They won’t go up by 5.3% per year. If the bank does grow deposits in the future the way it did in the past it will enjoy economies of scale at the branch level.
There will also be economies of scale at the corporate level. Let’s not even think about those. Each branch will increase its earnings faster than it increases its sales. Sales will – in the long run – track deposits. Per branch earnings will grow even faster than that. At a minimum, we are talking about deposit per branch growth of 5% driving earnings per branch growth of 6%. And so now you have companywide earnings – before stock buybacks – chugging along at 6% per year or better. That’s a lot different from 3% per year. We used the assumption of about 3% per year. We did it to be conservative. A DCF doesn’t use sales. It doesn’t use deposits. It uses earnings per share. Let’s pretend it just uses earnings for the whole company for now.
In the case of Bank of Hawaii, that means I could create a DCF with earnings growth of 3% per year or 6% per year. Which is right? Both are equally accurate, I’d say. I don’t think faster than 6% growth in per branch earnings is reasonable. And I don’t think slower than 3% growth in per branch earnings is reasonable. The range of reasonableness is 3% to 6% per year. Just with those two figures, you now have very different DCFs.
What’s more problematic is the terminal value. Bank of Hawaii wouldn’t start slowing down to 3% per year growth if it was doing 6% per year before then. There’s no reason for the bank’s “terminal growth” in say years 2046 to 2066 to be lower than the bank’s growth in 2016 to 2026. It’s just a mathematical convenience – a cheat – to lower the bank’s eventual growth rate to make sure it drops below the discount rate. It’s impossible to do a calculation with the growth rate higher than the discount rate. Of course, companies often have growth rates higher than an investor’s discount rate for decades and decades.
So, that’s why we don’t use a DCF. It’s impractical. How can we make a DCF practical? We can take snapshots of the same principle at static points in time. So, for example, we can take the impractical but theoretically correct DCF that covers the entire period from now to the end of time and break it down into a manageable chunk – say, the next five years – and do some simple arithmetic over that period. The growth rates would be compound numbers. I’ll simplify that here and let you just treat them as additive. A 3% growth rate is 100% plus 3% plus 3% plus 3% and so on. Five years later it’s not less than 1.15 times today’s EPS. And a 6% growth rate is 100% plus 6% plus 6% plus 6% and so on. Five years later it’s not less than 1.30 times today’s EPS.
That’s the range of reasonableness for a company that’s likely to grow earnings by 3% to 6% per year organically. Lots of companies can do this. Nestle can do it. Coca-Cola (KO, Financial) can do it. But so can steel companies and cement companies and railroads and cruise lines. What’s the difference?
A company like Nestle or Coke can often “have its cake and eat it, too.” This is critical. When we take a DCF and break it down into its simplest form – a one-year snapshot – we see that there are just three components. One, you’ve got your discount rate. When we break a DCF down into a one-year period, we can set the discount rate aside like it's sitting on the other part of the page from an inequality. In other words, we can just worry about the nondiscounted half of the math problem and then see whether this is “greater than” or “less than or equal to” the discount rate. If it’s “greater than” you can buy. If it’s “less than or equal to” you can’t buy. What are the other two parts of a DCF? There’s current period yield. Simply put, this year’s “crop,” the “harvest.”
Then there’s the growth in value. Simply put, this year’s “capital gain.” The increase in value of the farm you own. Take the Bank of Hawaii example. Bank of Hawaii would normally pay out 85% to 100% of its earnings. My very, very conservative assumption was that it would always pay out at least 80% of its earnings in a combination of dividends and share buybacks. This is the harvest you get. It’s the cash flow that goes out to you instead of having to be reinvested. Right now, Bank of Hawaii has a dividend yield of 2.6%. The company isn’t – on average – going to pay out more in dividends than it spends on share buybacks. The buyback yield is also no less than 2.6% at present. We add a 2.6% dividend yield to a 2.6% share buyback rate – and we get a 5.2% return of capital to you, the shareholder.
This is “eating your cake.” Now, personally, I’d prefer Bank of Hawaii spent every penny on share buybacks instead of paying any dividends at all. That would increase the value of the stock faster. It would also be more tax efficient for shareholders. But they’re not going to do that.
Other people would prefer the bank pay the full 5.2% “eat your cake” yield to shareholders in the form of a dividend. You can create this situation yourself by selling off your own position at the same rate the company buys back its own shares. In other words, you can sell off 2.6% of the shares this year if the company buys back 2.6% – and you’ll be in the same position as an investor in a bank paying a 5.2% dividend yield. The combination of buyback and dividend is the “eat your cake.”
What about the “have your cake” return? The “have your cake” return is the change in per share intrinsic value of the stock. In the case of a bank like Bank of Hawaii, this is most simply approximated as the rate of growth in deposits. If the bank’s deposit growth rate is 3% per year – your “have your cake and eat it, too” return is 8.2% per year. If the bank’s deposit growth rate is 6% per year – your “have your cake and eat it, too” return is 11.2% per year.
Banks like Bank of Hawaii have very high ROEs. And they should, in fact, trade for a higher price-earnings (P/E) multiple in the future than they have in the past. In other words, ValueLine is right for the medium-term trader. But it is wrong for the buy and hold Buffett investor. Buffett routinely invests in businesses like Wells Fargo (WFC, Financial), American Express (AXP, Financial), etc., that have outperformed the Standard & Poor's 500 for decades. Why? Because their “have your cake and eat it too” return is higher than the market by even more than their P/E ratio is higher than the market.
“Fair value” is the price at which a stock’s future return would be equalized with the S&P 500’s future return. I just did a report on Luxottica (LUX, Financial). And I think I’m going to shock you with this figure – but here goes – Luxottica’s “fair value” P/E is in the 25 to 30 range. Something like 28 times earnings is “fair value” for Luxottica. How can that be?
If Luxottica traded at 15 to 20 times P/E – like much of the S&P 500 does today – it would outperform the S&P 500. Let’s say Luxottica grows sales by 6% per year while trading at 25 times earnings. Well, for Luxottica, 25 times earnings is a little less than 25 times truly free cash flow. In other words, Luxottica converts earnings into free cash flow – money that can be used to pay down debt, buy back stock, pay a dividend or acquire another company – at a rate higher than 1 to 1. Over the last decade or two, it was like 6% higher free cash flow than earnings. So $1 of reported earnings turned into $1.06 of free cash flow. The company also grew.
It’s critical to count both these things. As an investor, you get both the growth and the payout. And there can be a trade off between the two. But what you want is always the highest combination of these two things. One or the other doesn’t matter. If a stock doesn’t grow at all, but it pays an 11% dividend yield, you should buy that stock. And if another stock doesn’t pay any dividend at all, but it grows 11% a year, you should buy that stock. People know this. Investors bid up the price of high dividend yield stocks and high growth stocks in such a way to keep these kind of opportunities from being that common. The trickier one to catch is the in-betweener. This is the combination stock. It has a solid, but not unbelievable dividend. And it has a solid, but not unbelievable, growth rate.
Let’s use Omnicom as an example. Assume Omnicom traded at a P/E of 15 to 20. It had a free cash flow yield of 6% per year. Now, assume it also grows its sales – and thus FCF – at 6% per year. Another company – a railroad – trades at the same P/E of 15 to 20. But this railroad only pays out one-third of its earnings in a dividend. Omnicom uses every penny of reported EPS to buy back stock or pay a dividend. They both trade at a P/E of 15 to 20. They both grow 6% per year. Which is the better stock to buy and hold? Omnicom. It’s not even close. The railroad returns 6% growth plus 2% dividend and buyback yield equals 8% a year. Omnicom returns 6% growth plus 6% dividend and buyback yield equals 12% a year. Huge difference. For the two stocks to be long-term equivalent in terms of expected future returns, a railroad would have to have a much, much lower P/E ratio than an ad agency. In fact, you can see this in the long-term result. If an ad agency went public 30-plus years ago and used all its free cash flow to buy back its own stock, it outperformed the market by a lot even while its P/E tended not to be lower than the market.
So, the idea of a “premium” is not because of stability. People often jump to that conclusion. And, yes, there may be a premium for Nestle or Coke because investors are especially sure of their future returns. But the “premium” you are talking about starts with the fact that earnings don’t matter. What matters is the combination of payout (dividend and buyback) and payout growth for the stock. A lot of times, a stock with a low P/E ratio isn’t converting a lot of that earnings into FCF while also growing. And a lot of times a stock (like Luxottica) with a higher P/E ratio is converting all its earnings into FCF while also growing.
The best explanation for why one stock is always priced above another stock is that the more expensive stock has historically outperformed the less expensive stock. Investors notice this. Sometimes it takes them a long time to catch on.
I’ll give you a case where the market hasn’t caught on to this yet –Â Atlantic TeleNetwork. I think the company may have changed its name to ATN International (ATNI, Financial). Either way, it’s the same company with the same ticker. It’s mostly a telecom company with some solar power now too. If you look at this stock, it’s often priced the same in terms of ratios like EV/EBITDA to AT&T (T, Financial) and Verizon (VZ, Financial). That’s clearly wrong. ATN has better management. It has better capital allocation. It is better focused on shareholder return. AT&T and Verizon have historically not been good capital allocators. They are bigger. They are predictable. But they should be priced below ATN. ValueLine probably wouldn’t tell you that because ATN is trading at a “normal” value relative to its own past.
But then go and look at the stock returns of ATN, AT&T and Verizon over the last quarter century. ATN has far, far outperformed those two companies. Should ATN “mean revert” to its own past when its own past was much, much better than peers? No. ATN was underpriced in the past. If the stock trades in line with its own history, it’ll continue to outperform. I’d say ATN is underpriced even though it is priced in line with its own history as a public company.
The same is true of Luxottica. Luxottica outperformed the market while trading at that price. A stock should only trade in line with its own past if that past average price multiple kept it returning about what the S&P 500 was doing. If a stock was doing 16% per year for 20 years while the S&P 500 was doing 8% per year during those same years – we can say, in hindsight, that the stock was priced too cheaply. The kind of true mean reversion you are talking about doesn’t admit that some businesses are inherently higher return than other businesses. It doesn’t admit that banks and ad agencies should trade at higher P/Es than railroads whether or not the market has acknowledged that in the past.
The market tries to be rational – sure. But, when you look at something like ATN versus AT&T and Verizon, you can see it has consistently overvalued the behemoths relative to the tiny, hodgepodge peer. ATN is less well known than AT&T and Verizon. But it’s the better stock – mostly because it has the better capital allocators. It has never gotten credit for this. It has always tended to be underpriced. You want to find stocks like that. Stocks that appear normally priced but are cheap. ATN looks like it is priced in line with AT&T and Verizon. It looks like it is priced in line with its own history. But its own history as a stock was better than other stocks. It can be a good buy even when it seems in-line with its own historical mean price.
Disclosure: No positions.
Start a free seven-day trial of Premium Membership to GuruFocus.
