Where Does a Stock's Future Return Come From?

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Mar 21, 2013
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Someone asked me a question about a stock I own called Ark Restaurants (ARKR, Financial):

Right now the stock price is $21 vs. a 10-year average FCF of only $1.68/share and a FCF margin of less than 4%. I appreciate that they are good stewards of the shareholders' money in returning cash in the form of dividends. It looks like in the last 10 years they've not retained any earnings -- they're returning all the earnings to shareholders. At the same time, revenues are nearly flat and FCF is not growing. Looking at it through this admittedly myopic lens, it looks like my return on investment is going to be roughly in line with the FCF yield of 8%, presuming no future growth…Can you help me put this all together?”

That’s a great question. The first thing I want to say is that this isn’t really an article about Ark Restaurants. I own the stock. But I don’t think it’s the kind of stock most people reading this will have any interest in. What should interest everyone, however, is why I think a can get a good return in the stock.

After all, if the stock is trading at an 8% free cash flow yield, and it isn’t growing – how can you ever make more than 8% in the stock?

The key reasons you might get a better return are:

One, it actually will grow a little.

Two, it will take very little retained earnings to grow.

Three, the stock is undervalued and this undervaluation will close over time through a rising stock price.

Four, there is the possibility that something will happen within just a few years to give you a high annualized return.

Those are common reasons for buying a stock when the free cash flow yield alone is not high enough to justify an investment. In this case, it’s about 8%. That’s not low. In fact, most stocks trade for much more than 12 times their 10-year average free cash flow. But the question is asking whether the stock is doomed to return only 8% - or whether it might return 8% or more under some scenarios.

I bought the stock. So, I obviously think returns above 8% a year are possible. How can that be?

Let’s start with the company’s long-term history.

Over the last 22 years - as far back as EDGAR has sales data for Ark - the company has grown sales by 5.9% a year. As they say in their reports, they do not normally experience same store sales growth over time. This is typical of restaurants that are run as separate businesses with their own brand names, locations, etc. unlike the national "concepts" like Chipotle and McDonald's and Darden and OSI and Cracker Barrel and all of those. These restaurants - although located in hotels, casinos, landmark places, etc. - are basically each like your local restaurants near where you live and where you probably go out and where no one from just a couple towns over has ever heard of. These are like those businesses. You mentioned BDMS. This has a similarity to those in the sense it's ultimately a local business at the individual store level.

Now, to me, 5.9% annual growth looks a lot like nominal GDP growth. So that has me interested. I like the idea that growth may create value (because it may require less capital than growing the same amount at other companies, investing in the S&P 500 might cost, etc.). Here is one way I think of it. Assume I believe that the S&P 500 will return 7% a year over the next 15 years. Now, how much will it cost me to grow through the S&P 500? It will cost $1/0.07 = $14.29. If I believe the S&P 500 is priced to return 7% a year, then I have to put $14.29 in the S&P to get one dollar of wealth growth this year.

Now, let's think about Ark. Ark has - using your 10-year number - about $1.68 a share in normal free cash flow. The stock costs $20.31 a share as I write this. So it costs me $12.09 to grow my wealth by $1 using Ark's free cash flow. This is a bit better than my estimate of what it would cost me to invest in the S&P 500 with the idea of holding my shares for the next 15 years and earning 7% a year. It is also, a lot lower than the probably a little over 16 times free cash flow at which the S&P 500 normally trades. Also, a quick check at GuruFocus tells me that the S&P 500's Shiller P/E is currently 23. Ark's Shiller P/E - if we substitute free cash flow - would be 12. The S&P 500 has tended to grow around 6% a year. Just like Ark. In fact, if we look as far back as we can into Ark's history and as far back as we can into the Dow Jones history (which is further than the S&P 500) we will see both tend to compound at a little less than 6% a year.

Finally, we have the question of what the growth is worth. I think Ark can make the growth more valuable than the S&P 500 by growing the same amount while retaining less earnings. In other words, I think Ark's growth will be lower cost. Now some might argue with me here. After all, the S&P 500 has a higher return on equity than Ark right now. Ark doesn't use financial leverage in the form of bonds and bank debt. It does have leases. I think they are mostly good leases in the sense that Ark is able to manage a good cash flow generating location without putting in as much capital as they'd have to if they owned the place and yet they can - and do - walk away from locations when the lease no longer makes sense. I also think that Landry's interest - since they have some business with similar location based restaurant approaches - supports the idea the leases are not a terrible weight around Ark's neck.

For these reasons, Ark has been able to earn about 18% on their capital - as you mentioned in your email. Morningstar - which doesn't net out cash - gives the number as 15.6%. I'll round down for the sake of conservatism. And we'll assume Ark can - over a full cycle - earn about 15% on equity. Meanwhile, we will assume - this is perhaps too aggressive, we'll see - that Ark will grow about 6% a year over time. We will use Ark's 10-year past free cash flow average of $1.68 a share as today's normal "owner earnings" figure and our starting point.

The key assumptions in our valuation of the company look something like this:

· Growth of 6% a year

· Cost of growth of $6.67 per $1 of growth (i.e., 15% incremental ROE)

· Owner Earnings of $1.68

· Share Price of $20.31

· S&P 500 expected return of 7%

Let’s make this real. Let’s say we buy 3,000 shares of Ark for $60,930. What does that buy us?

It buys owner earnings of $5,040 ($1.68 * 3,000). Now, let's tackle growth. I have no idea to what extent Ark's sales will be up or down from year to year. I know about the hurricane. I know they closed a failed location. I know they signed a new deal for a new location. I know they bought more of a joint partnership they were already operating. We won't worry about any of that here. We are worrying not about what earnings will be next year but what they will be in a Shiller P/E sense. We only gave Ark credit for earnings averaged out over 10 years. So, we are only looking for Ark to lap the last decade by 6% as they go by. In other words, we are looking for a 6% annual rate of decade over decade increases in owner earnings. I won't get into whether or not that is likely right now. I'll just assume it is.

Ark is earning $5,040 on my $60,920 investment right now (assuming that 10 year average earning power number of $1.68 a share we are using). If Ark grew earnings by 6% it would grow what it earned on my investment from $5,040 to $5,342.40. That's an increase of $302.40. If we assume - as we did above - that Ark can earn a 15% incremental ROE than Ark will have to invest $6.67 for every $1 of growth it achieves. That means Ark would need to keep $2,017 of my money to grow my owner earnings by $302.40 for next year. What happens to the rest? Ark is assumed to earn $5,040 on my 3,000 share investment. Then they retain $2,017 to grow by 6%. The rest of that amount - $3,023 - can be paid out in a dividend or used to buy back stock. I would prefer they used it all to buy back stock. So let's assume they pay it all out in a dividend instead. That's a 4.96% dividend yield ($3,023 / $60,930). However, that yield is before tax. Let's assume I pay a 15% dividend tax. In that case, I get only $2,570 in dividends. The other $453 goes to the IRS. So, now I have 3,000 shares of Ark Restaurants (a company that is 6% bigger) and $2,570 to show for my original investment of $60,930. It is a full year later. I have earned a 4.22% after-tax yield. This compares pretty favorable with after-tax yields on bonds, other stocks, etc.

I also have my 3,000 shares of Ark Restaurants and most importantly the $302.40 my owner earnings grew. Remember, this is a fantasy scenario. Ark's earnings may very well be lower next year. We are doing this all based on an assumption that normal owner earnings are the 10-year past average and future growth will be 6%. For the sake of explanation, we are making that a smooth 6% a year rather than a lumpy decline of 10% then an increase of 18% etc. even though they both get you to the exact same place.

What is the value of that $302.40 increase in my owner earnings? Well, the Shiller P/E we always talk about has a historical mean of 16 times earnings. A lot of investors consider a number around 16 to be normal. And in those cases we are talking about earnings rather than free cash flow. We are using free cash flow as our gauge of owner earnings. So, I will - despite all the complaints I can hear about this being a micro cap, a controlled company, terribly illiquid, etc. and therefore needing a lower P/E - assign a normal cap rate of 16 times earnings to that $302.40 increase in my owner earnings. That works out to $4,838.40 in an intrinsic value increase.

So far my investment in Ark Restaurants is looking something like this:

· Paid $60,930

· Received $2,570 in after-tax dividends

· Experienced $4,838 intrinsic value growth

· Still own Ark Restaurants common stock (a security with no maturity date)

Now, we need to tackle that last part. I think Ark Restaurants’s common stock is cheap. Not so cheap that if it couldn't pay dividends or grow or earn a good return on equity or do any of the things long-term investors depend on that it would be a good investment. Ark isn't that kind of cheap. This is not a stock Ben Graham would put at the very top of his list. This is not deep value. But it does fit the value stock mold. It is a comparative value. I think - and I guess Landry's thought - it was a bit of a private owner bargain too.

I think Ark is a 75 cent dollar. I think that you are paying a little over $20 right now for a stock that Landry's wanted to buy at $22 and I think was fairly worth about $28. You can quibble with my estimate. I won't defend it. It's just the back of the envelope approach I would take to giving a fair appraisal of the company. If you use peer comparisons of what EV/EBITDA multiple other restaurants were sold at and if you do the Shiller P/E approach you used before (where Ark scores a Shiller P/E of 12 vs. a normal Shiller P/E for the market being 16) you end up with similar conclusions. If you used a particularly relative to the moment approach - I'm using restaurant acquisitions over the last 7 years - you could find deeper discounts. For example, the market has a Shiller P/E of 23 right now versus 12 for Ark. I won't use a comparison like that. It would be far too aggressive. It assumes today's stock prices are perfectly correct for the S&P 500. I don't like that kind of approach.

What does this 75 cent dollar approach tell us?

There are a few reasons to buy a stock. Value investors tend to focus on the valuation gap. Dividend investors tend to focus on yield. Growth investors tend to focus on growth in EPS in the future. Quality investors tend to focus on free cash flow, growth in free cash flow, and maybe return on equity.

Part of buying Ark today can be seen as a pure investment for yield approach. We talked about that. We can peg that at 4.22% after-tax. That's the investment component. Then there is the growth value of the company. This is a speculative and contentious issue. No two people will agree on this one. I said Ark could grow intrinsic value by 6% a year. However, because I think I am paying $60.930 for something worth $81,240 (75 cents for a dollar) this 6% growth yield on face is actually an 8% growth yield at market. In that sense, I think the current buyer of Ark stock is getting paid:

· 4.22% after-tax in dividends

· 8% in intrinsic value growth

· And still owning a 75 cent dollar

Let's look at that 75 cent dollar. Today, you can pay $60,930 for 3,000 shares of ARKR. I think the actual value - right now - of those 3,000 shares should be $81,240. This is not based on future growth assumptions discounted back to the present or something. This is based on what I think the company should sell for today in a negotiated transaction. I could be very, very wrong. The only offer the company got was a $22 hostile offer. So I don't have a smoking gun here. But let's say you agreed with me that Ark is a 75 cent dollar.

How does this result in wealth creation for you? Well, you plunk down $60,930 to buy 3,000 shares of Ark. We assume - at some point - you will get $81,240 back. Maybe you'll get that from the open market (if Ark stock rises 33% at some point). Maybe Landry's will pay that to you in cash. Maybe someone else will come along and you'll get cash and stock in some deal. Maybe nothing will happen until the founder (and controlling shareholder) of Ark dies. I can't answer these questions. Stocks don't come with maturity dates. That doesn't mean they aren't 75 cent dollars and it doesn't mean that gap won't close.

What does that do for you? Well, it obviously gives you a gain of $20,310 (before-tax) at some point. Hopefully, it will give you a long-term capital gain. It might even give you the opportunity to keep the stock (since the gain comes in the open market) or roll your stock over into another public company (if someone issues shares to buy the company). Again, I can't answer those questions. So, I can't answer when you'll get paid or how much you'll have to pay in taxes. But the assumption here is that you will make $20,310 pre-tax at some point. This is your capital gain. It's equivalent to what a bond buyer of a 75 cent dollar gets when that dollar matures. Of course, stocks don't have maturity dates. But I want to avoid the confusion of assuming that someone buying a bond yielding 13% really wants to collect 13% in interest over time rather than get a capital gain. We absolutely do not know that. I own two American stocks. Both have dividend yield over 4%. I didn't buy either for the dividend. I don't mind the dividend. But if they could just buy back stock with my dividend I'd be happier in each case.

So now we have the three potential parts of Ark wealth creation:

· The investment component: A 4.22% after-tax dividend yield

· The speculative component: A 6% growth rate (which is 8% if bought at 75 cents on the intrinsic value dollar)

· The value component: A $20,310 capital gain (caused by investing $60,930 in a 75 cent dollar)

Each of these are potential sources of profit for the investor. Some are quick and flashy and unlikely. If Ark is bought out by another company at the price I think it's worth within the next year, the annual return could be 40%. If the growth never materializes at all but the capital gain is earned over a period of 5 years where the value gap closes and I collect dividends along the way - then the annual return would be 10%. It would take share price appreciation of 6% a year to turn a 75 cent dollar into a 100 cent dollar if the dollar never grows. Also, there'd be that 4.22% dividend after-tax. Before tax, the return would be about 11% without any growth but with the dividend and the value gap closing over 5 years.

We can look at the investment this way. It should yield about 4.22% after-tax. For comparison, this is going to be equivalent to a 5% dividend yield for individual investors. So, there is a 5% a year investment return here. There is also a value return here. This is the valuation gap. It's a one-time capital gain. The value return is inversely related to the time you hold the stock. Let's take a look at how buying a 75 cent dollar works out over different holding periods:

1 year: 33%

3 years: 10%

5 years: 6%

10 years: 3%

15 years: 2%

Excluding the speculative - growth - component of the stock we can focus on our expected investment returns by combining the dividend yield and the capital gain caused by the one-time undervaluation being eliminated. These are the two sturdiest parts of our return potential in Ark. When added together they look something like this:

1 year: 33% + 5% = 38%

3 years: 10% + 5% = 15%

5 years: 6% + 5% = 11%

10 years: 3% + 5% = 8%

15 years: 2% + 5% = 7%

So our return - even with the dividend included - still has the familiar decaying annual return pattern of a no growth stock:

1 year: 38%

3 years: 15%

5 years: 11%

10 years: 8%

15 years: 7%

Then there is the growth kicker. I won't try to value that. I'll just say Ark did grow about 6% a year over the last two decades. And it has earned about a 15% return on equity. Since we are saying we're lucky to get 7% a year investing in the S&P 500 right now, that means that growth where you earn 15% a year is obviously value creating. Under those circumstances, a dollar of earnings retained that earns 15% a year should be valued more highly than a dollar of earnings paid out in dividends. None of the investment return calculations of Ark's possible future returns assigned any value to retained earnings at the time they were retained. All we assumed so far is that a 5% dividend would be paid (dividends aren't retained earnings by definition, so that's irrelevant). And we assumed someone would one day - in the next 15 years - pay us one dollar for each dollar of intrinsic value Ark possessed. We also assumed Ark is priced at 75 cents on the intrinsic dollar.

A buyer - whether in the public market or a private owner - is concerned with earnings only as a gauge to the future earnings the company will earn while he owns it. He obviously gives no value to past retained earnings. He simply estimates future earnings.

Therefore, we haven't counted the potential growth kicker. And we won't. I'll just say it was 6% once. And it is worth more than a dividend if it’s earned as a 15% return on equity. If you want to assume there is a potential kicker in the stock that could add more than 6% a year to your returns - you can certainly make that assumption. I would just caution that it remains - as Buffett would say - a kicker.

The investment return on the stock itself ranges from about 7% over 15 years to 15% over 3 years. I consider the 38% return potential shown under one year to be another form of kicker. Something could happen in the next year or two. Let's keep that in mind. But we don't have to quantify it.

So I view Ark as an investment with a 3-15 year time horizon promising a return of 7% to 15% over that period. I think this 7% to 15% security has two kickers attached. So to sum up:

· An investment offering 7% to 15% returns

· That could offering a higher "event" return within the next 2 years

· And that could grow in a way that creates value over time

I think it's an especially good combination. The event possibility - caused by cheapness and an interested competitor - increases the short-term potential. It's a 75 cent dollar where a competitor made a hostile bid. That can help goose your chances on an above average result within 3 years. Then you have a kicker that could help with the long-term holding period. Without growth, the returns in this stock will decay from about a 15% expectation over 3 years (which is quite acceptable) to an 8% return over 10 years (which is no advantage over alternatives). Without any growth, the investment's outperformance as an investment occurs only if the market, a control buyer, etc. recognizes the intrinsic value I see in the stock within about 5 years. If that doesn't happen, we have a problem. Now, I think even a relatively small amount of growth - if it's value creating - can solve this problem and keep Ark stock an acceptable (although not mind blowing) investment even if held indefinitely. In other words, I think the potential for some profitable growth can keep your returns for holding periods as long as 6 to 20 years to be perfectly fine. In my book, perfectly fine is anything that:

1. Beats the market

2. Returns at least 10% a year

With even rather slow growth - as long as there is some growth at a good ROE - Ark can add enough value each year to deliver an acceptable return over an indefinite holding period. I wouldn't want to hold it indefinitely. I'd want the 75 cent dollar to become a dollar dollar within the next 5 years. But I would feel I could hold it indefinitely. That is very important.

So I think there is enough here to support an indefinite holding period. I think a holding period of something like 3 to 5 years is likely to result in good returns. Good enough for me to switch out of cash and into Ark. And I think there's a lottery ticket attached where maybe you get really good annual returns through some event happening within the next 3 years.

Simply put, you've got a higher than average chance of a good short-term return. You have an above-average medium term return promised. And I think - if you get any growth - that the long-term return is something you can live with.

Is Ark the best investment I've ever seen?

No. It's far from it. But I think it's a better investment than stocks generally, I think it's a better choice (for me) than cash right now, and I think it offers acceptable returns over all future time periods. That's all you need to switch from cash into a stock. And since I was 75% in cash before buying Ark, it was only a question of comparing Ark to cash. It checks all the boxes it needs to check to get me out of cash.

When I'm 100% in stocks, I'll let you know. And I'll let you know how Ark compares to the other things I own and the other stocks I might want to buy. At that point, it's a different test. Ark would have to pass the best alternative test. Right now, it's a low bar because I've got more cash than ideas.

Eventually, something other than cash will be my best alternative. In that case, an investment priced to offer 7% to 15% annual returns with the potential – probably unquantifiable – to maybe make a better annual return if something happens in the next few years, may no longer be good enough.

When the alternative is cash, it’s good enough. You always have to decide on investments relative to your own alternatives. My alternative here was cash. I was deciding between buying Ark or nothing. I was not interested in buying anything else. And I had 75% of my portfolio in cash. I wasn’t going to put 75% of my portfolio in Ark. So, there’d be room for another stock even after buying Ark.

If you’re 100% invested in stocks right now, you would need to use different alternatives to make your decision. You would need to decide if it was worth selling something you own to buy Ark. That’s a much higher hurdle.

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