Friday, July 13, 2012

Viable Stock Market Investments – Part VI

We have looked at the financial statements of corporations with unlimited growth potential. We learned that their growth rate is dependent and limited by their return on equity unless they use leverage (or issue shares). We have looked at an example of a company with nearly unlimited growth potential Microsoft. First we thought that there was virtually no debt financing, but then we realized that deferred taxes, accounts payable and potential legal liabilities also are forms of leverage but at an interest rate that is virtually zero. It is not only the debt equity ratio that should be considered; one also has to look at the ratio of liabilities (excluding shareholder equity)/shareholder equity

We have gotten insight into the IPO deals that are offered to investors and learned that the initial (founding) investors make out like bandits along with the investment bankers that administer the IPOs. We also learned that there is a significant difference in valuing an investment based on book value and based on earnings. This is why founding investors do so well and today, we’ll focus on whether there is a lesson for our own investment strategies (other than avoiding IPOs).
Now, we’re looking at companies that have mature growth prospects, companies that don’t have revenue grow faster than nominal GDP. We often pay attention to real GDP growth, i.e. economic growth adjusted for inflation. But really the economic output is also affected by inflation as it drives revenue up when product prices increase and it also drives up the cost of production, hence nominal GDP growth is also very important.
We assume that in spite of being in a mature market the competition is not strong enough that companies cannot increase their product prices at the same rate as inflation. Also, we ignore the impact of economy-of-scale and that unit production costs are optimum and cannot be lowered.

We’re starting with the unlevered or debt free company:
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Figure 1. Debt Free Income Statement
Basically we’re noting that if return on equity doesn’t change (figure 2) then net earnings grow at the same rate as revenue growth - in this case at the same growth rate as nominal GDP or 5%. To keep up with demand, each year part of the net income has to be invested to expand product at a compound rate of 5%. Note a compound rate of 5% equals an annual rate of 5.1%

The remainder of net income is paid to the investors as dividend. So let’s look at the balance sheet and at the Per Share Numbers and Ratios in figure 2.
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Figure 2 Debt Free Balance Sheet and Per Share Numbers and Ratios.
Each year, we retain enough net income to expand production by 5% and return the remainder to the investor as a dividend. This results in a payout ratio (Dividends/Net Income) of 44%. The retained earnings are each year added to shareholder equity. Note that in our spreadsheets we’re adding the retained earnings to shareholder equity at the beginning of each year while in many real financial statements, retained earnings are calculated on a cumulative basis.

Since there is no debt, the companies total asset value is shareholder equity. As stated in our initial posts of this series, there are 10 million outstanding shares, thus in year 1, the net earnings per shares are 18 million divided by 10 million or $1.80 per share as shown under the ‘Per Share Numbers and Ratios’. Since net income growths at a compound rate of 5% and a non-compounded rate of 5.1% so do the earnings per share provided that no new shares are issued or no shares are bought back.
The dividends paid out in Year 1 are 80 cents per share and based on the book value per share that is a yield (dividend/share price) of 4%. Return on equity doesn’t change because the profit margin doesn’t change and neither does tax rates and interest rates.

During year 1, the company went public and did an initial public share offering (IPO). Here is the thing all investors should pay attention to! Initial investors or founding investors paid book value for their shares. In other words, they paid for the assets of the company. But the stock market investors often pay for the company’s earnings. How much profit do these assets make for me?  Stock market investors ask how much they earn on each dollar invested not how much they pay for the company’s assets.
Thus, the new stock is often priced at the same rate as shares of competing companies. In our example, companies in the same industry as our company are valued by the stock market at PEs ranging from 11 to 13. As our company enters the market, the issuers of the IPO (founding investors and their investment bankers) want to sell at the highest possible price; the stock market investors want a new ‘fast growing’ profitable company at an attractive price. So, they agree to price the IPO at 12x earnings or 12 x $1.80 = $21.60.  The founding members paid $20 for each share, so their profit is $1.60 for the year or 8%. They also made sure they collect the year’s dividend before going public and thus collected another 80 cents. That is a dividend yield of 4% based on their $20 investment. Yet, in later years, the dividend yield is based on the stock market share price and if the shares keep trading at 12x earnings, the dividend yield for the IPO buyers is 3.9%
Thus for the founding shareholders, return on their shares including dividends is 12% (8%+4%) in year one, while in later years, the return is only 8.9% Now what do you think that leverage would do to this scenario?
At the start of year 1, the founding shareholders went to the credit market and obtained debt equal to 50% of their total assets. Thus, shareholder equity was $100 million and debt was $100 million creating the same $200 million asset value as the debt free company has. With the same profit margin, they also had an operating profit of $20 million from which they paid taxes and interest on the debt. Since the interest was paid to create the business, it is part of the costs of doing business and thus it is tax deductible.
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Figure 3. Income Statement of levered company
Hence, income before taxes is operating income minus interest or $17 million resulting in taxes of $1.7 million rather than $2 million for the debt free company. Effectively, the levered company does not pay $3 million but only $2.7 million for its credit.

Still, Net Income of $15.3 million is less than the $18 million for the debt free company and so is net income per share: $1.53 versus $1.80. Dividends however are higher because to grow by 5%, only half the expansion costs are paid from net income, the rest is borrowed! The shares pay $1.03 instead of $0.80 in dividend. The payout ratio is a lot higher: 67% instead of 44% of net income is paid out to investors.

With the company going public in year 1, the founding investors receive a dividend yield of 10.3% on their initial investment of $10 per share versus 4% for the founding investors of debt free company which made 80 cents on $20 invested.  Also, the return on their equity (earnings/equity) has increased dramatically from 9% to a whopping 15.3%. But that is nothing compared to the profits they make when going to the stock market.
Remember: the stock market pays for earnings, the founding investors paid for assets! At 12x earnings the stock of the levered company sells for 12 x $1.53 or $18.36 slightly less than the debt free company. But the profit is $8.36 on $10 invested or 83.6% rather than 8%! If you add the dividend yield the founding investors made in year 1 93.9% or $ 9.39 per share!
Also, the stock market investors make out better than those in the debt free company because their ROIs in the following years are 10.9% versus 8.9%. But… that is only true when things go as planned. The public shareholders in the levered company incur a lot higher risk than those in the debt free company as shown in an earlier post of this series.
Not only that. What if the shareowners of the now public debt free company decide to take on 50% debt? Where would the profits go? Yes, they would go through the roof for the stock market investors would bought the IPO because those shareholders bought a company at a price much closer to book value than the ones in the levered company.
Benjamin Graham, the mentor of Warren Buffett and the father of value investing, wanted only to buy companies at book value, or even better, at a 10% discount of book value just to be safe! To do so, you have to buy during market down turns, when there is ‘blood in the street’ and when investors are in a panic selling at ridiculous low P/Es and often at low price to book values.
Our accounting system is not perfect. There is room for number fudging and also, it is basically geared towards manufacturing companies. How would you reflect the rising value of real estate in a company?  How would you reflect the asset value increase in an oil company that has added new oil and gas reserves or whose reserves value has changed along with changing oil and gas prices. How do you reflect the value of patents and other intellectual property owned by companies such as Apple and Microsoft?
We’ll talk about that a bit more in our concluding post(s) on this topic.
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Figure 4 Balance Sheet and Per Share Numbers and Ratios of levered company

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