Monday, August 3, 2015

Is buying shares in TD a speculation or an investment?

A bank is a crazy business. You have the shareholders who put up money.  The money put up by investors in TD including reinvested profits was in 2014 around 47 billion dollars. Wow you may say. They own some 1846 million common shares or each share represents $25.67 equity not counting preferred shares and other forms of equity. But the bulk of the bank’s equity is from common shareholders. The $25.67 per share is called book value.

If you think $47 billion is a lot of money, than better know that the bank manages around $905 BILLION in money with some $660 billion from deposits by people such as you and me in bank accounts. TD also borrows in the bond market for the long term (longer than 12 months). So what are they doing with all that money, nearly $960 billion?  They earn income by lending it to us as mortgages, to corporations as their lines of credit, to car owners, to Visa Card holders, etc. When all is said and done; after wages are paid, interest paid on your deposits (hahaha!), taxes are paid and the ATM machines are expended, etcetera then there is some $7.5 billion left which we call net revenue or plain profit or earnings or… loot J
So shareholders earn $7.5 billion on $47 billion in equity. That is a return on common share equity of around 15.9%. Half or precisely 49.9% of those earnings is currently paid to the shareholders as dividends or $3.7 billion, that is a lot! Yeah, that is a measly $2.04 per share which translates in a dividend yield of 3.8%.

Wait a minute, the bank paid already taxes over the earnings and thus over your portion of the dividends. So when you receive those dividends from say a U.S. corporation like Wells Fargo, the Canadian Government hoses you by taxing it again at your top margin tax rate minus that what the U.S. government has already withheld!  Is the Canadian Government not incredibly generous  for not taxing you twice when the dividends come from a Canadian company? It is called the Canadian Dividend Tax Credit. I call paying any tax on dividends a benevolent form of theft. Not as bad as being taxed on U.S. dividends but still they got you. Yes you’re evil because you’re an owner of a Canadian bank so let’s make sure we get something extra from you after your corporation has already been taxed just… because.
But… thanks to the Canadian Dividend Tax Credit, you are doing at least better than if you invested that money in GICs instead. First of all, where do you get 3.8% on a GIC? Secondly, your tax on the 3.8% interest is a lot higher than on the 3.8% dividend.
HOOOOO!!! Wait a minute! $2.04 dividends is not 3.8% of $25.67!  Yeah you’re right because you cannot buy a TD share for $25.67 today in the stock market either! You see, the current share price in the market is $52.77 and the dividend yield of 3.8% is based on $2.04/$52.77.  Why should you pay $52.77 in the market while you only get $25.67 equity in the bank?  Well…. The auctioneer says: The more you pay, the more its worth! Right from that song by Don McLean… remember young baby boomer… eh grasshopper?
The difference between the actual share price and the equity you own in TD, also known as book value, is the premium the investor pays to the previous share owner. Why would you pay extra?  Well, because not all dollars invested in assets are created equal. Take a GIC of $100 dollars and it pays 1% interest… Wow that much? A whole $1 dollar per year?  Yes these are desperate times. So what if I knew an investment, nearly as safe, that makes $3.8 plus a tax credit! How much would that be worth to you? Also $100? Does $380 sound fair? You may say: “No there is more risk than in a GIC”. Really? Well, suppose you’re right.
What about paying $25.67? You go:”….eh… ehh…” Before you can finish the sentence, that nasty neighbor of yours shouts, “Are you kidding? I’ll buy it for $52!” Now you get pissed and shout: “I was here first and I’ll pay $52.77”. Pffff… thank God, you won the bidding and got the investment for $52.77. You look at the investment and, shoot! it is a share in TD!  So now you know there is the stock market price and the par price or book value of that share which in the case of TD is $25.67
The difference between a GIC and shares is that the GIC’s par value does not change but that of a share can. For example, a company may buy back its shares. TD could use part of its profits not for lending out to its customers but to buy its own shares, especially when those shares are cheap!  What means cheap?  Well, you could look at what the dividend yield of a share is. Say the yield is 5% then you could consider the stock cheap and worth buying back. The effect of the buyback would be that the company’s earnings have to be shared amongst less shares. Here’s the math: $7.5 billion earnings to be divided by 1,846 million shares or earnings of $4.09 per share. If TD used $1 billion dollars earnings to buy shares back at $52.77 per share it reduced the number of outstanding shares by approximately 19 million. The $7.5 billion earnings would then translate into $4.13 per share (7.5 billion divided by 1,827 million remaining shares) and an increased dividend to $2.06 from $2.04. All that without TD earning a penny more. If the P/E (price-earnings ratio) paid by the market remained the same as before the buyback then TD shares should increase by 55 cents to $53.32 because of the increased earnings and thus your shares increased in value, tax free, by nearly 10%.
Alternatively, TD’s total earnings will not stop to increase either. Remember TD earned $4.09 per share last year and it paid out $2.04 in dividends. So what happens with the remaining earnings of $2.05? They are reinvested in the company! That means, share book value increased from $ 25.67 to $27.72 and remember TD earns around 15.9% on its common share equity. Thus, assuming TD’s profitability does not change, next year earnings per share should be 15.9% of $27.72 = $4.42 The result is a dividend increase from $2.04 to $2.19 and the stock price should increase to $56.98 based on the P/E of 12.9. So overall next year you will earn  $2.19 in dividends and the stock should increase by 56.98 minus 52.77=$4.21 for a total one year profit of $6.40 on an investment of $52.77 or 12.2%  Do you like that?  A lot better than a 1% on a GIC, I would say!
Well, you can extrapolate this way the earnings growth and dividend payments over the next five years and calculate that by then the share price should be $73.74 and a dividend of $3.00 (49.9% of $6.01). Now that is investing; it is not pure calculation, you still had to make some assumption : namely that things at TD stay more or less the same as they have been over the last 5 years or so. But analysis is still a lot better than having to speculate that the price will go up or down because of changing interest rates, economic growth or the oil price, or the gold price. In your analysis it is assumed that management controls the internal factors of the company. External factors such as GDP growth or interest rates are beyond management control and require speculation by the investor. You can find our  calculations or more precise our simple analysis of TD shares in the  spreadsheet below:

When we're analyzing a stock and calculate what the shares should be worth 1 or 5 years forward we value the stock based on 'fundamentals'  But now that you estimate what the stock is worth and want to invest in it you have to buy it in the market. Well, you may have calculated that $52.77 is a good price that will give you likely a good return, but when you put a bid in for that price, you may find out that TD's share price has changed during your analysis.

You see in the market TD's share price is changing continuously depending on the most crazy considerations. It might depend on whether Russia is invading the Ukraine or whether Greece defaults or whether it is summer and everyone is on vacation, it changes may be purely random (in the short term). The market may react to a stupid story in the news paper or on the web. Many people buy TD or sell TD because they 'feel' that it will be worth more by tomorrow and next they may find out that the price actually fell that following day and often sell in a panic.  This is not much more than a form of gambling or speculation.

Only if you have analyzed the stock and you have calculated what it's future value should be as well as how much dividend income will be paid, only then are you truly investing in an asset with a future income stream. That is just like investing investing in a rental property, or in the business of your brother in law. I hope you get my drift,

So knowing all this, do you now better understand how you 'invest'?  Are you an investor, a speculator or a bit of both?

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