In chapter 10 of “Stocks for the Long Run,” Jeremy Siegel noted and asked, “Earnings drive stock prices, and their announcements are eagerly awaited by Wall Street. But exactly how should we calculate earnings, and how do firms turn these earnings into stockholder value?”
He began with a discussion of discounted cash flows. The “cash flow” component is straightforward; it is the cash that is expected for owning a particular asset, whatever that asset is. The “discounted” component refers to the fact cash in hand today is considered more valuable than cash promised in the future. There are three reasons why that view is held:
- A risk-free rate does exist, the yield on safe assets such as government and other AAA-rated securities.
- Inflation, which reduces the value of cash received in the future.
- “The risk associated with the magnitudes of expected cash flows,” prompting investors to demand a premium to take on the additional risk.
These three factors are also known as the “required return on equity” or “the cost of equity.”
Cash flows to investors are sourced from earnings, which are also known as “profit” or “net income.” Earnings are the difference between a company’s revenues and its costs. Those costs include everything a company has spent (including the cost of depreciation) to produce its products or services.
Earnings that flow to shareholders take several forms, but the main channel is dividends. More broadly speaking, earnings is an abstract term on a financial document, while a dividend is actual cash arriving in a shareholder’s account.
If the company decides to hold some or all the earnings, that portion is known as “retained earnings” and will be applied to internal opportunities. Those opportunities should create value by raising future cash flows, in one or more of these ways:
- Retiring debt to reduce interest costs.
- Investing in other assets, including other companies.
- Investing in capital projects to increase future cash flows.
- Buying back shares, which increases the value of the remaining shares.
Siegel considered buybacks to be the third source of shareholder value, after cash flows and earnings. This happens when the company buys back some of its own stock from shareholders, thus reducing the share count and increasing the future earnings per share. Buybacks do not affect the share price at the time of the repurchase, but over time they will. The author explained that an increase in the growth of earnings per share will increase share prices; this means shareholders who continue to hold their stock will have capital gains rather than dividends they otherwise would have received.
Over the roughly 140 years between 1871 and 2012, dividends were “by far the most important source of shareholder return.” This table from the book shows details (NIPA refers to data from the National Income and Product Accounts):
Overall, the real returns over these years averaged 6.48%, made up of 4.40% from the average dividend yield and 1.99% from the average capital gains yield.
As illustrated in the table, the dividend payout ratio has been lower since 1946. According to Siegel, dividend tax rates increased sharply at the end of World War II, affecting the way companies distributed their income. In addition, since management stock options are based on share prices, it has been in the interest of executives to follow a low-dividend policy because that pushes up share (and option) prices.
Following up on the latter point, Siegel also wanted readers to know how dividend policy affects the price of stocks. To explain, he referenced the Gordon Dividend Growth Model, which was introduced by Roger Gordon in 1962. It is a mathematical model based on the solid assumption the price of a stock is present value of all future dividends. For the mathematicians among us, the formula looks like this (g=future dividends growth rate, P=price per share, d=dividend per share and r=required return on equity):
Siegel added, “Since the Gordon model formula is a function of the per share dividend and the per share dividend growth rate, it appears that dividend policy is crucial to determining the value of the stock.” Dividend policy can be neutralized, however, if a company earns the same return on its retained earnings as on its required rate of return on equity.
He said the theory was borne out by long-term data. The average dividend payout ratio was 71.8% before World War II. In the 70 years since the end of the war, the dividend payout ratio has averaged 49.6%. That pulled the dividend yield down almost two points, from 5.26% to 3.43%. But, at the same time, capital gains have risen roughly two points, meaning the total returns both before and after World War II are about the same. The lower dividend yield led to an acceleration in earnings per share growth.
Also on Siegel’s list of concerns was the practice of pricing stocks based on the present discounted value of future earnings. He argued the price of a stock should always equal the present value of all future dividends, and not the present value of future earnings. As he explained, earnings can only have value if they are paid as dividends or other cash disbursements in the future.
Another issue of importance are the ways in which earnings can be reported. Earnings are always more than simply money-in and money-out, because some revenue and costs extend over multiple years; think of multiyear contracts on the income side and capital spending and depreciation on the costs side. There are also “extraordinary” items that add to or subtract from earnings one time only.
Going further, Siegel explained there are two types of earnings reporting methods:
- The Generally Accepted Accounting Principles (GAAP) established by the Financial Accounting Standards Board; these are the official results used in annual reports and government filings.
- Operating earnings refers to unofficial standards or accounting practices, and which provide flexibility in compiling the corporate books. Standard & Poor’s has its own “strict” version of operating earnings in which it excludes asset impairments and severance pay associated with these impairments.
Finally, Siegel noted earnings that “beat” or “miss” the Street’s estimates are based on operating earnings.
(This article is one in a series of chapter-by-chapter digests. To read more, and digests of other important investing books, go to this page.)
Read more here:
