Let us do a mathematical experiment here. A company earns $10 per share and out of that, pays a dividend of $8 per share. If one were to apply a 20 times multiple in the dividend stream going forward , the value of the dividends in perpetuity is $160. So we could make the argument here that the company is worth at least $160 if the dividend stream is fairly consistent. The $2 per share in retained earnings could lead to some real growth in the future. So if an investor decides to pay $100 per share for that company, that would be considered a good buy from an investor’s stand point.
But if this same company trades at $180 per share , the market is in effect putting a value on growth. Perhaps the company could put the retained earnings to work here and create a sustainable growth in earnings per share. Maybe, just maybe, $180 may still be a fair price to pay if return on asset figures are above industry average.
And then I will paint a 3rd scenario here. Same company. Same earnings. Same dividend payout ratio. Earnings is $10 per share. Dividends paid is $8 per share. But now, the market pays $250 for it, anticipating a 10% annual growth in earnings per share for the next 5 years. The markets value the company at a 25 times TTM PE ratio and if the same PE is applied to approximately $16 per share in 5 years time, then the price of the company would be $402.63 . The investors would have gained. Perhaps management would increase the dividends paid to shareholders. All are happy or so it seems.
The retail investors are happy. The institutional investors are happy. The market is happy. But this is really dependent on the assumption that the PE multiple does not change.
The problem with this is that the PE ratio really depends on the whimsical moods of the market. If the PE changes to 20, the price of the company would be closer to $322 in 5 years time.
Now, this is often what I see being played out so often in the markets. Still referring to the same company. The company misses on its projected growth and instead earns a dismal $8 per share in 5 years. So the earnings per share has in effect fallen for 5 years. Then, a snowball of sorts begins even before 5 years is up. Investors question the capabilities of management. Institutional investors want out. Next, retail investors want out. Speculators want out. And by the time you know it , the company now trades at a PE of 20 times. And at that PE, in 5 years, the company should trade at $160. But if the markets accorded a lower PE of 10 times, we are talking about a dismal price of $80. At that price, investors would have earned huge losses on the investment.
One of the blindspots is this. The company has an earnings per share of $10 initially. Of which, it pays $8 to common equity holders. So it pays a large proportion of its earnings in dividends. The earnings need only fall slightly more than 20% for the company to be unable to resume paying a $8 dividend. And from experience, falling dividends mean falling share prices. The thing about investors is that they look mostly at the recent 12 months. And that points to a whole lot of recency bias within their system. The other thing is that they tend to believe management and put on very aggresive growth projections . As a result, they tend to pay a darned high price for growth. Now the other thing is this. The damn PE multiple has a way of changing when you need it to trade at a high multiple.
This is the problem with paying for growth. People often tend to overpay. Everyone is guilty of this to some extent with exceptional cases of course. We tend to be overoptimistic on growth. We tend to apply the wrong multiple to our projections. We tend to fail to see the risk in that kind of thinking. We tend to want it to work so bad that we develop these blindspots. And did I say, we tend to believe everything that management says and all the splashy headlines of the day. Aren’t we guilty of all of that?
The way to look at this company is this. Project the dividend that the company can pay in stressed situations and normal conditions. Average that. Apply a sensible multiple to the dividend streams. And then pay just that or less! This becomes the no brainer baseline price that you are willing to pay. And you are paying nothin for growth! Nada! Zilch! And at $80, you might very well pick it up and ride it all the way back to a price greater than $100.
I am not saying that you can’t pay for growth. All I am saying is don’t pay a terribly high price for growth. At the end of the day, it is the risk reward ratio that counts and within the risk reward concept, one should have this lesson etched in memory. You should pass on the supposed opportunity when it fails on risk and reward. It is also a matter of opportunity cost! Go for the investment with a more favorable risk reward profile!
In another article, I spoke briefly about glamour stocks and the unloved stocks. You may want to take a read of that article. Within the article, I posted a real life case study of one Dairy Farm. It would be an interesting read if you consider this article useful, meaningful and sensible. Here is the link to it.
Remember that all I am saying is don’t overpay for growth. But if you do figure out that this type of investing is for you, then by all means go ahead. I have had the pleasure of viewing some investments made by investors who happen to know and practise this style of investing really well. And some have done a fantastic job of it. This style of investing is sometimes called growth at reasonable price. Some have even called it the value growth strategy. I believe that Warren Buffet practises this. He believes that value and growth are both joined at the hip! How eloquent! But, we have to note that he possesses a set of skills beyond the kent of most investors. My humble opinion anyway – do not pay for growth if you can help it!