Saturday, June 23, 2012

Viable Stock Market Investment – Part II

Case I shows numbers of a corporation with an unlimited product market that can grow regardless of the economy. We used to call such companies ‘recession proof’; they are often companies with new innovative products that people want no matter what the economy does.  When Apple’s iPods came out everyone wanted one and Apple just couldn’t produce enough of them to keep up with demand.  For several years, iPod sales grew enormously.

In our example company we also assume that no matter how much is produced, the production costs don’t change. For simplicity, we do not consider the effects of ‘economy of scale’. Neither do we consider the effects of competitors and supply that exceeds market demand on product pricing. The profit margin is constant (10%).
Finally, we assume that the company is not borrowing any money. Its working capital is restricted to equity brought in by the investors, i.e. $20 per share. We’re looking at 3 years of data; in real life, most investors look at 5 years or even 10 years of data.

Just like with the real estate’s APOD we’re starting with the income and operating profits. Below is the Income Statement:

With the sale of 10,000,000 shares at $20 each the company acquired $200,000,000 in capital which was used to produce $200,000,000 in merchandise and to sell it with a profit margin of 10% for total revenue or sales proceeds of $220,000,000 including $20,000,000 (twenty million) operating profit.  This is akin to the Net Operating Income from a rental property.
Since no money was borrowed, all profits go to the shareholders after corporate taxes which are set at a flat rate of 10% or 0.1 x $20,000,000 = $2,000,000. Thus on an after tax basis shareholders made $18,000,000 profits in year 1. Wow, I didn’t know that accounting was that complex!

Well, the balance sheet is even easier. It is shown below.

The Balance Sheet basically shows the companies’ financial structure. It shows where the capital came from, how much it is at a specific date (e.g. at the company’s fiscal year end) and who owns the capital, shareholders, lenders, the government (taxes), unpaid suppliers, etc.
Our corporate structure is simple; there are no loans and the taxes were paid from this year’s profits and nothing is owed to the government. The only contributors to capital are the shareholders. At the beginning of year1, the shareholders put in $20 per share of $200,000,000 overall and they made an after tax profit of $18,000,000.  What is being done with these profits?

Well, the operating profit could be paid out as dividends; in fact all $18,000,000 could be paid to the investors as dividends. Since the corporation already paid corporate taxes, the government will tax you less on the dividends than on other income such as salary or interest income. That is the reason for dividend tax credits on your tax credits. If you had invested in a foreign company then the Canadian Government did not collect taxes on your company’s income and then why should it pay you a dividend tax credit? In that case, those dividends are between you and the foreign country’s tax man!

Did you see the profit margin on your investment? $18,000,000 divided by $200,000,000 million? That is close to 9%! Wow, that is a lot better than you’d make on a GIC today! So what are you going to do with your share of the profits? Invest it in a GIC at 2% per year?  Wouldn’t it be better to re-invest it in the company and make 9%?

How would you reinvest? Buy more stock in the stock market?  What if the company was not publicly traded? You couldn’t buy stock no matter what you paid? If you bought in the stock market you would have to pay stockbroker commissions and you have to pay the current stock market price which could be a lot more that $20! So your 9% profit would go down to 7% or even less!

You might wish that management never paid out the dividend and just kept it with the company!  Then your initial investment would grow at a compound rate of 9%. You would make 9% on your initial twenty dollars and also on this year’s profit!  What?  What was it that management said?  “Can do! We want to grow the company; we need money to expand and we don’t want to pay money to raise new capital. Just let us keep your money and we make next year another 9% after tax for you!”

“Peleaaaase!”, you may want to shout out. ”Yes I don’t want dividends. Just grow the company!”  Thus the company ‘retains’ your earnings and now your shareholder’s equity is not $20 per share or $200,000,000 for the entire company but also includes the $18,000,000 in retained earnings. The equity per share or the book value per share is now $20 plus $18,000,000 dividend by the 10,000,000 outstanding shares or $21.80! Total Shareholder Equity at year end is $218,000,000. 
Would you sell your share now for $20 per share in the stock market? No Way! You’d want at least $21.80 and since there is no other investment that would compound at 9% per year, you would probably want more!
So we’re keeping the money in the company and use it to produce even more in year2 and yet more in year3. Lo and behold, each year we’re earning 9% on our money and each year our earnings increase and so does the share’s book value. 

So what could the market be doing during those 3 years?  If interest rates and inflation stay unchanged, other investors would love to own part of your company. They would want it even if it earned only 7% per share rather than 9%.  If you sold your shares at the end of year2 for its book value of $21.80, the buyer would earn in year2 $1.96 per share. He would have an forward earnings yield of 1.96/21.80 = 9% or a forward price/earnings ratio of 21.80/1.96 = 1/9%= 11 .1

If the buyer used this year’s earnings of $1.80 the earnings yield would be $1.8/21.80= 8% or a P/E of 12.1 So the lower the earnings yield, the higher the P/E and if a buyer was willing to buy your share for an earnings yield of 7% or P/E of 14 it would bring you not $21.80 but $1.80x14= $25.71. Would you sell for a $5.71 capital gain on a $20.00 investment?
If you could invest your $25.71 elsewhere for a 9% compound rate, I think you would sell in a jiffy. Heck, you would sell if you only could earn 7% because you’re not sure whether the company can keep on growing every year at 9%. That is what should go through your mind when you consider both company financials and market valuations! 

Some investors may be willing to pay even a higher P/E if they thought that the company could keep on generating 9% on its equity for several more years. These investors may think: "Heck, the economy looks good, everyone is happy. There is virtual no risk to buy this company."

Or… investors don’t believe that 9% growth is sustainable. Because who can afford buying more and more product when the Europeans are about to go bankrupt, and China’s economy is growing only 7% per year and Obama is president in the U.S. and if the world is coming to an end? These guys would not even pay a P/E of 8! Your $20 share sells only for $14.40 in the stock market. Ouch you are in a bear market! Oh we’re all going broke! Two months later, or 6 months later, for some mysterious reason, everyone is happy again and then your company is selling for a P/E of 13. Earnings were better than the analysts expected.

No matter all the speculation in the market, your company is likely to keep on producing and made $1.96 in year 2 and another $2.14 after tax in year 3. If you sold finally in year 3 to someone willing to pay a P/E of 13, you made 13x$2.14= $28.00 or a profit of $8.00 while your company earned $5.90 over the same period. Hmmm…. The combination of real earnings and market psychology can be quite profitable but is this investing or emotional dithering?

I'll tell you. Your company ownership is an investment. Trying to sell it in the market for a profit by taking advantage of the emotional dithering of others is smart. Getting affected by the market emotions is a sure recipe for losing your investment cool and losing money.

The other thing we're learning from all these numbers is that if the profitability of a company doesn’t change then no matter how much it grows, return on equity will not change either. In order to increase earnings per share, the production costs have to come down or the company should increase its product's price (if the market allows it). Or… the company could have another capital structure by using other forms of capital such as preferred shares and borrowed money.
If you can borrow investment money at an interest rate of 3% to earn 9% would that not be sweet? We'll investigate in a later post.

No comments:

Post a Comment