A company that is growing earnings and paying a dividend is compensating for the wait, substantially reducing the dead-money risk. The growth dimension comprises both growth of profitability (earnings or cash flows growth) and dividends (dividend yield).
Dividends are real-time compensation for the wait for growth. Growing earnings are compressing the valuation bounce under the stock.
It is important to know the sources of a company’s profitability growth. Profitability growth could be portrayed as a pyramid placed upside down, where revenue growth is at the wider top of the pyramid and net income, free cash flows, earnings per share, and free cash flow per share flow to the narrower bottom.
Revenue growth is the most natural way for a company to grow. There are several organic strategies for a company to grow revenues:
· Selling more products and services to existing and/or new customers.
· Expanding to new markets, domestic or international.
· Raising prices whose success depends on elasticity of demand.
A second source of growth is margin improvements. Margin improvements may come from different sources, such as operating efficiency and economy of scale.
As regards operating efficiency, they have been the most common source of margin expansion for most U.S. companies in recent years, as technological innovations have helped companies to become more efficient. The issue is related to cost cutting. When cost cutting becomes universal among competitors, the cost structure among them becomes similar. The competition is likely to drive prices and companies’ margins lower, and customers will be the final benefactors of lowered operating costs as they receive the fruits of improved efficiency in lower prices. Therefore, it is difficult for a company to keep the benefits from superior operating efficiency in the long run.
As regards economies of scale, they are a more sustainable source of margin expansion. Two things have to be present for economies of scale to materialize: sales growth and large fixed costs.
A third growth element is stock buyback. Stock buybacks and nice, fat dividends create shareholder value. They reduce the risk a company has to take to produce a total return for shareholders as it accelerates earnings per share and dividend growth.
It should be noticed, though, that stock buyback generates value if the stock is purchased cheaply, but they often destroy value when management overpays for the stock. Stock buybacks when a stock is undervalued make sense as it is a value investor. In addition, buybacks help EPS growth and raise dividend yield at the same time as the buyback lowers the EPS denominator.
Buying back stock is leveraging the balance sheet. The problem comes along when buybacks take place through debt increases. In this case, the amount of debt and interest expense rises. On the contrary, stock buybacks sourced by free cash flows result in more sustainable earnings growth and are arguably less risky.
Generally speaking, growth can come from different sources as it has just been explained. But investors have to be careful. A source of growth that was successful in the past, not necessarily is profitable in the future. So the situation has been thoroughly analyzed to see if the past source of growth can be projected.
As an investor it is important to focus on companies that have several growth engines. This reduces investment risk. Why is that? If one growth engine fails or temporarily stagnates, the company can turn to other growth engines.
Looking back to the sources of growth, it is theoretically considered that there is no difference between dividends and stock buybacks. Unfortunately for those who follow this thought, there is a difference in practice.
Even when earnings take a turn for the worse, companies often increase dividend payout to maintain the dividend. Share buybacks, however, are optional. Though a company may have authorization to buy back a certain amount of stock, the execution is under management’s control.
On a theoretical level, dividends are just a transfer from a company’s corporate account to the shareholders’ brokerage accounts. Thus there is a transfer of hypothetical wealth to real wealth. Dividends are a superior choice to earnings growth, as once dividends are paid out they cannot be returned, whereas earnings can be reversed if a company gets into trouble.
Dividends serve as bear market protectors. A decent dividend instills confidence about a company’s business.
There is also a myth that high dividend payout inevitably involves a slow earnings growth. However, that is not the case. The reality is that a great portion of publicly traded companies have passed that stage and generate plenty of free cash flows that are available to pay higher dividends.
Higher dividend payout puts discipline in place but doesn’t hurt the growth prospects.
Growth is a very important value creator, as it helps to fight the P/E compression of the range-bound market. It should not be approached in, but it should be a very important component of the investors´ analysis.
Dividends are real-time compensation for the wait for growth. Growing earnings are compressing the valuation bounce under the stock.
It is important to know the sources of a company’s profitability growth. Profitability growth could be portrayed as a pyramid placed upside down, where revenue growth is at the wider top of the pyramid and net income, free cash flows, earnings per share, and free cash flow per share flow to the narrower bottom.
Revenue growth is the most natural way for a company to grow. There are several organic strategies for a company to grow revenues:
· Selling more products and services to existing and/or new customers.
· Expanding to new markets, domestic or international.
· Raising prices whose success depends on elasticity of demand.
A second source of growth is margin improvements. Margin improvements may come from different sources, such as operating efficiency and economy of scale.
As regards operating efficiency, they have been the most common source of margin expansion for most U.S. companies in recent years, as technological innovations have helped companies to become more efficient. The issue is related to cost cutting. When cost cutting becomes universal among competitors, the cost structure among them becomes similar. The competition is likely to drive prices and companies’ margins lower, and customers will be the final benefactors of lowered operating costs as they receive the fruits of improved efficiency in lower prices. Therefore, it is difficult for a company to keep the benefits from superior operating efficiency in the long run.
As regards economies of scale, they are a more sustainable source of margin expansion. Two things have to be present for economies of scale to materialize: sales growth and large fixed costs.
A third growth element is stock buyback. Stock buybacks and nice, fat dividends create shareholder value. They reduce the risk a company has to take to produce a total return for shareholders as it accelerates earnings per share and dividend growth.
It should be noticed, though, that stock buyback generates value if the stock is purchased cheaply, but they often destroy value when management overpays for the stock. Stock buybacks when a stock is undervalued make sense as it is a value investor. In addition, buybacks help EPS growth and raise dividend yield at the same time as the buyback lowers the EPS denominator.
Buying back stock is leveraging the balance sheet. The problem comes along when buybacks take place through debt increases. In this case, the amount of debt and interest expense rises. On the contrary, stock buybacks sourced by free cash flows result in more sustainable earnings growth and are arguably less risky.
Generally speaking, growth can come from different sources as it has just been explained. But investors have to be careful. A source of growth that was successful in the past, not necessarily is profitable in the future. So the situation has been thoroughly analyzed to see if the past source of growth can be projected.
As an investor it is important to focus on companies that have several growth engines. This reduces investment risk. Why is that? If one growth engine fails or temporarily stagnates, the company can turn to other growth engines.
Looking back to the sources of growth, it is theoretically considered that there is no difference between dividends and stock buybacks. Unfortunately for those who follow this thought, there is a difference in practice.
Even when earnings take a turn for the worse, companies often increase dividend payout to maintain the dividend. Share buybacks, however, are optional. Though a company may have authorization to buy back a certain amount of stock, the execution is under management’s control.
On a theoretical level, dividends are just a transfer from a company’s corporate account to the shareholders’ brokerage accounts. Thus there is a transfer of hypothetical wealth to real wealth. Dividends are a superior choice to earnings growth, as once dividends are paid out they cannot be returned, whereas earnings can be reversed if a company gets into trouble.
Dividends serve as bear market protectors. A decent dividend instills confidence about a company’s business.
There is also a myth that high dividend payout inevitably involves a slow earnings growth. However, that is not the case. The reality is that a great portion of publicly traded companies have passed that stage and generate plenty of free cash flows that are available to pay higher dividends.
Higher dividend payout puts discipline in place but doesn’t hurt the growth prospects.
Growth is a very important value creator, as it helps to fight the P/E compression of the range-bound market. It should not be approached in, but it should be a very important component of the investors´ analysis.
