The Dividend Imperative: How Dividends Can Narrow the Gap between Main Street and Wall Streetby Daniel Peris
IF YOU’RE INVESTED IN THE FUTURE OF THE STOCK MARKET, THIS IS YOUR WAKE-UP CALL.
You’ve seen the markets swing from bubble to scandal and back again. You’ve watched the divide between Wall Street and Main Street grow larger each year. You’ve wished there was a strategic approach to investing that strengthened portfolios,/p>/b>
IF YOU’RE INVESTED IN THE FUTURE OF THE STOCK MARKET, THIS IS YOUR WAKE-UP CALL.
You’ve seen the markets swing from bubble to scandal and back again. You’ve watched the divide between Wall Street and Main Street grow larger each year. You’ve wished there was a strategic approach to investing that strengthened portfolios, benefited companies, and bolstered the economy as well.
The answer, according to business investor Daniel Peris, is simple. You need to focus on dividends.
Investors need to demand bigger dividends and U.S. corporations need to pay out more of their profits as dividends.
This is THE DIVIDEND IMPERATIVE.
A powerful new call to action for investors and corporate leaders by the acclaimed author of The Strategic Dividend Investor
“Peris makes a compelling case that investors and companies need to focus more on dividends, which have accounted for the lion's share of stock market returns.”
—John Heinzl, Toronto Globe & Mail
“All investors and corporate leaders can benefit from Peris’s simple insight.”
—J. Christopher Donahue, CEO, Federated Investors
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THE DIVIDEND IMPERATIVE
HOW DIVIDENDS CAN NARROW THE GAP BETWEEN MAIN STREET AND WALL STREET
By DANIEL PERIS
The McGraw-Hill Companies, Inc.Copyright © 2013 Daniel Peris
All rights reserved.
Stocks Go Up Because Dividends Go Up
The fundamental principle which applies here is that the value of capital at any instant is derived from the value of the future income which that capital is expected to yield.
Irving Fisher, The Nature of Capital and Income, 1906
For an institution that is supposed to offer instant and correct valuations of businesses, the U.S. stock market does a stunningly poor job of it. So says a dividend investor. And so should say any rational observer watching the market rise a few percent one day and go down by the same amount the next. How is one to navigate such a landscape? In the spirit of offering investors something beyond Wall Street's self-serving mantra of "buy low, sell high, and repeat frequently," let's review a few basics: what a business is worth, what a P/E is, why too many companies and investors focus on near-term earnings, and why that focus gets both in a muddle.
What's a Business Worth?
The conventional wisdom encourages investors to think of stocks, first and foremost, as things that are traded, go up, go down, and, if you are lucky, are bought by someone else at a much higher price than you paid for them. But what is behind those stocks? Businesses. And that's where we will start. What's a business worth? The stock market is supposed to be a means of valuing businesses, but it long ago ceased being the means and became an end unto itself. So for a moment, banish stocks from your mind and think about enterprises—large, privately held businesses, or the neighborhood dry cleaner, or your insurance agent's book of business, or the family-run chain of diners, or the local widget manufacturer, or even the company that you work for. You need not be constrained by size, by sector of the economy, or by geography. And ask yourself: how are these businesses valued?
It might help to step back and review the basic business valuation techniques online or in your long-abandoned college finance textbook. If it's your own business, think about how you regularly monitor the value of your own undertaking, what you do when you buy another business or consider offers for your own. Despite the bewildering array of methods that investors use to value stocks, business valuation comes down to a few basic concepts. The first and most basic is income—what a business or asset generates to the owner on a regular basis. That income stream and any projected growth in the payments are discounted back to the current time to determine a present value, the price you might consider fair to purchase the business. This can be dressed up in many ways, but it's really nothing more than a standard DCF (discounted cash flow) exercise. No PhD required. Despite its core simplicity, a DCF does have subjective inputs, notably the discount rate (used to come up with a present value of the future payments) and the projected growth rate of the income stream, and there are a lot of adjustments that can be made—multiple growth stages, control premiums or discounts, and so forth—but the basic math is straightforward. And consistent with that simple math, the percentage rate at which the distributions grow is what drives the change in the present value (holding the other factors equal). In short, the value of an enterprise rises in line with its distribution growth over time. If little Johnny's lawn- mowing business generates 10% more pocket cash for Johnny one summer compared to the previous one (and the higher level is sustainable and the other inputs are unchanged), the value of that business—however it is determined—should rise by the same amount. The same is true of IBM. Stocks go up (over time) because dividends go up.
But let's entertain, at least for a moment, an alternative view, that of relative valuation, which is the second major way that businesses are assessed. This approach asks what a similar asset, business, or stock has recently been bought or sold for. And there's nothing wrong with this method if the "base" enterprise has been valued properly, on an income basis. Make a few adjustments to reflect how the companies are different, and you have a reasonable estimate of worth. Alas, that is rarely the case on Wall Street. Rather, relative valuation has taken on a life of its own, with no regard for intrinsic value. It is purely relative to what a company might have sold for in the past or relative to the price of other companies.
While the seller might not care which method of valuation is being applied as long as he or she feels that the price is right, the buyer most certainly should be considering not only what other similar businesses have been valued at, but whether the intrinsic value is there—the ability of the business to generate profit distributions that, when netted back to the present time, are equal to or greater than the purchase price. Or to put it another way, paying $50,000 for a dishwashing machine may seem like a good idea if your neighbor had to pay $60,000 for the same washing machine a week ago, but it still doesn't make it a wise investment. Extend the logic to buying a tech stock in early 2000, and you get my drift. At that time, you could hear brokers extolling the virtues of some stock because it was 10% cheaper than its average, or, worse yet, selling at a 15% discount to the peer group's P/E. Fifteen percent less bad is still bad. Relative valuation is just that, relative, and limiting your analysis solely to what other people are buying is an excellent way to lose money. It is in the markets as it is in life. Doing what everyone else is doing may explain a poor decision, but it is no excuse for one. You may be able to get away with relative valuation strategies for years at a time—like riding Nasdaq stocks in the late 1990s or the financial bubble a decade later—but it doesn't make it a valid long-term strategy, even if all your friends and peers are investing the same way. Ultimately, all businesses are subject to the same rules of financial math, and those are based on cash flows to the owners. It's the same for an apartment building, a manufacturing enterprise, a professional service corporation (doctors, lawyers) or even—I daresay—a stock in a publicly traded company.
Now there are real differences between how you might value a small, local business (e.g., Johnny's lawn-mowing operation) and a global corporation (IBM) whose shares trade on the stock market. Liquidity—the ability to easily purchase or sell your stake—is something the stock market offers investors. You might not always get the price you want, but between 9:30 a.m. and 4 p.m. every business day, there are buyers and sellers of IBM in the marketplace. That is worth something. Having lots of similar companies available in the stock market probably helps, through a network effect, to raise the value of all of them. Publicly traded status also offers investors the luxury of owning part of a business without having the obligation to run it. That's worth something, too. (We'll discuss the downside of this luxury later.) On the other hand, owning a small slice of IBM means you don't control the enterprise, whereas if you buy Johnny's lawn-mowing business, you get to call the shots. My analogy has its limits, but at its heart, it is still correct: a business is a business is a business. Companies whose shares trade on public exchanges are not, by virtue of that simple fact, somehow subject to a different set of rules.
Given (mostly) free markets and the general availability of basic operating information, the prices for businesses on the stock exchanges are supposed to come pretty close to intrinsic value. Having thousands of investors doing their DCFs on a daily basis and making investment decisions accordingly should get buyers pretty close to the "right" price for a business. That is, the DCF-based valuation exercises and the relative valuation ones should end up converging and giving you a good idea of what a business, and perhaps even a stock, should sell for. This is what is believed by those who hold that the capital markets are "efficient." Alas, the reality is quite the opposite. Near-term, the market is not efficient, and the wild gyrations in stock prices make it quite clear that most investors are not doing their DCFs, or if they are, they are using wildly unrealistic assumptions such as growth rates that are too high and discount rates that are too low. (In periods of crisis, the opposite may be true—growth is underestimated and risk is rated too high.) Long term, the market has to be and is efficient, but that is small comfort for investors worried about their portfolios now.
What's a P/E?
Let's get a little closer to the relative valuation exercises that are so broadly accepted on Wall Street. In almost all instances, investors are using valuation "multiples," the price of a stock divided by some per-share figure, usually net earnings (the P/E ratio) but sometimes sales (P/S) or a version of profits called EBITDA (earnings before interest, taxes, depreciation, and amortization) for those companies where interest, taxes, depreciation, and amortization would consume most if not all of the profits. But the most widely used, by far, is the P/E multiple. So what exactly is a P/E multiple, and how does it work?
This will likely come as a surprise to most investors, but earnings multiples are just a shorthand way of expressing the key components of a DCF analysis. Bear with me while I review the math, but if you can make your way through the next few pages, you'll be better positioned to understand why you need to focus on cash distributions when you make investments. At its simplest, the P/E ratio reduces a stock's value to the inverse of the discount rate being applied to the stock's current earnings forecast out into the future. Whoa—what's that actually mean? It means that if you hear that a stock has a P/E of 8, the stock is selling for 8 times current net income on a per-share basis. That P/E ratio implies that, assuming earnings stay where they are, investors are applying a 12.5% discount rate (8 = 1/0.125) to the company's future profit stream to account for the risk that those profits might not be delivered or might not be worth as much in purchasing power tomorrow as they are today. Add up all those future earnings discounted back to the present time at 12.5% per year, and they will sum to 8. That's a pretty high discount rate for the types of large, publicly traded corporations one might encounter as part of the S&P 500 Index, and that's why a major stock with a P/E of 8 is considered to be cheap. Take a company with a P/E of 20, and it suggests that investors are using a discount rate of just 5% on that flat stream of future profits. In contrast, that is quite a low discount rate, which makes the stock expensive.
So the next time you are told that a stock is trading with a P/E of 10 or 20, you can puff out your chest, quickly do the math in your head, and opine with a definite swagger as to whether the implied discount rate is too high or too low. But do discount rates really go through the minds of investors when they are contemplating the P/E of a stock? Of course not. Investors use the P/E not as shorthand for discount rates, but as a simple measure of how expensive a stock is relative to its history and relative to other stocks. Price per share divided by profits per share. Period. Lower is better than higher, and if it must be high, let it at least be less than it has been in the past, or at least lower than the P/E of similar businesses. That's pretty much it. In an only marginally more sophisticated manner, a P/E can be viewed as a measure of a "payback" period. That is, if a stock costs $100, earns $10 per share, and has a P/E of 10, purchasers will get their money back in one decade. Lower payback periods are better than higher ones. This notion does not take into account either inflation or the rather obvious fact that what a company earns is not necessarily what the investor gets.
P/Es are convenient and allow comparison between similar entities, but, like any shortcut, they can be a little too simple. Notably, they assume flat, constant earnings into the future. Many investors believe that companies with legitimate growth potential can therefore support higher P/E ratios. But those long-term growth prospects come with a higher risk of falling short. Thus, as one factor moves up, so too would the offsetting one of the discount rate. Hence investors can employ a P/E as a simplified form of a DCF analysis and use it to compare broadly similar enterprises. In the case of close companies in one industry, say Hershey Foods (HSY) and Campbell Soup (CPB), where the growth rates and discount rates might reasonably be expected to be similar to one another, the P/E ratio is not entirely without use.
But whether stock market participants realize it or not, when using P/Es to value investments, we are back to the underlying notion of the income approach. Why is a DCF behind the P/E calculation? Because in the end, all financial investments have to be valued on the basis of an explicit (DCF) or an implied (P/E) cash flow analysis. There is no other way. The value of any business (or any other type of investment) is the summation of current and future income to company owners discounted to the present time. It was that way 100 years ago; it is that way now; it will be that way two centuries from now. There are other ways to value a business that may be relevant in some cases—what it would cost to replace physical assets (OK for manufacturing enterprises, not so good for brand or service businesses), contingent values based on certain circumstances such as a buyout (high discount rates), and so forth. But when looked at closely, they too end up being some variant of a DCF. Investors should take comfort from this. There is a system, and despite the fact that market participants ignore it much of the time, it does work in the long run.
The dividend discount model (DDM) is just a specific instance of a DCF where the cash flow being valued is the actual dividend received by the company owner. It's the relevant form of the DCF for large, publicly traded companies that have and distribute profits. In cases where all the cash generated is paid out to company owners as a dividend, the DCF and DDM will be identical. That is the theory. In current stock market practice, however, DCFs are used to value the profits that are in the hands of the corporate managers, not the company owners. Company owners may have a claim on those profits in a legal sense, but they do not see them except when they get their quarterly checks in the mail, assuming the company pays a dividend. But as the dividend payout ratio in this country remains stubbornly around 30%, the dividend discount model applied to a public company's declared dividend is going to yield a far smaller value than the DCF applied to all the cash being generated by the corporation overall. In theory it should not, as the 70% of the profits that are reinvested back into U.S. businesses (not paid out) are supposed to generate a higher growth rate in the future profits that are paid out as dividends. Oh, that it would. The problem is simple: that 70% left in the hands of corporate managers isn't always well spent. (We'll take up one of the biggest ways it is not well spent in a subsequent chapter.) As a consequence, the current low payout ratios that characterize many large, publicly traded U.S. corporations do not always (in fact, rarely) generate the higher dividend growth trajectory used to justify sending out such small profit-sharing checks to company owners in the first place.
And so we're back to the dividend payout ratio. Companies with legitimate growth prospects do and should reinvest some or even all of their profits—perhaps for many years—to take advantage of those growth opportunities. That is, a DDM based on a company with a low payout ratio should have a higher growth rate in the equation. But I'll just remind you again of that devilish little discount rate going up in tandem with the expected growth rate of profits. Sustaining very high rates of growth for very long periods of time is the rare exception, not the rule, despite the examples of Google (GOOG), Amazon (AMZN), and the piles of business plans sitting on the desks of venture capitalists in Silicon Valley that promise to touch all Internet users or new consumers in China and India.
At this point, you are probably asking what on earth am I going on about, and what does this have to do with the stock market? Rightly so. So let me return to the matter at hand. Investors in the stock market should value companies on the basis of DCFs of the dividends paid to company owners. They do not. Instead, they use relative valuation, most notably of earnings multiples, or P/Es. The next section takes a look at P/Es and suggests why, in their current form, they are not a very good way of valuing stocks. P/E ratios are no longer particularly useful, not because of the P part (price is there for all to see) but because the E (the supposed earnings in this simple equation) have become largely unusable.
Excerpted from THE DIVIDEND IMPERATIVE by DANIEL PERIS. Copyright © 2013 by Daniel Peris. Excerpted by permission of The McGraw-Hill Companies, Inc..
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Meet the Author
DANIEL PERIS is a senior portfolio manager at Federated Investors in Pittsburgh. Trained as a historian, Peris is also the author of The Strategic Dividend Investor. Find out more at www.dividendimperative.com.
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