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ROIC, Growth and Dividend Policy



September 17, 2012 – Comments (2)

I'm a big believer that the value of a stock is related to the stream of dividends that the stock actually pays. After all, what good is a stock if my only means of profiting from it is to sell it to some other chump willing to pay more for it, eventually I'm going to run out of chumps (but not for a long time I suspect). But when I focus on the stream of dividends that I will receive over the course of its life, I don't have to worry about finding some chump. I can just sit back and watch the cash roll in.

But there's something to be said for a company to retain its earnings and reinvest those earnings so that future dividends will be that much better. So the big question is this: when should a company retain earnings and when should it pay out dividends?

To analyze this, we'll look at a simple example. We'll assume that a stock, XYZ, is financed entirely with equity (no debt) and that their cost of capital is 10%. In other words, the company is selling at P/E of 10 (assume that earnings are "owners earnings" if you want to be picky). 

Let's assume that XYZ is selling for $100 so their earnings are $10. They could pay out those earnings as a dividend. But would it be worthwhile to retain those earnings? 

That all depends upon what return on invested capital (ROIC) that XYZ could get by retaining those earnings. Let's consider three cases.

Case 1) ROIC > Cost of capital (COC)

For concreteness, let's suppose that ROIC is 15%. Now if XYZ decides to reinvest those $10 of earnings, they will get a return of $1.50 (15% of $10). As a result future earnings will be $11.50 ($10 + $1.50). And assuming that the P/E remains constant (cost of capital is constant), then XYZ is now worth $115.

So if you had received the dividend you would have $10 in cash and $100 worth of XYZ stock for a grand total of $110. But if they reinvest and earn 15%, you end up with $115 worth of stock, a much better deal!

Case 2) ROIC = COC

In this case ROIC = 10%. Now if XYZ retains the $10 in earnings and they will increase earnings by $1 (10% of $10). As a result next year's earnings will be $11 and XYZ will be $110. 

So in this case it makes no difference if XYZ paid the dividend or retained it as you will still end up with $110. 

Case 3) ROIC < COC

It should be noted here that short seller James Chanos often looks at this criteria as a good indicator of a possible short candidate. There's a reason for this as will be shown.

Let's assume ROIC is 5% for concreteness. So instead of paying out a $10, they reinvest it earning 5% increasing earnings by $0.50 (5% of $10). Future earnings are now $10.50 making XYZ worth $105. 

So here we can see that instead of having $110 ($10 dividend and $100 in stock) we now just have $105 worth of stock. Thre result is that when ROIC < COC, growth destroys value. And that's typically a troubling sign (and perhaps makes the stock a good short candidate!)

So the big question to ask is whether or not management is getting a good return by retaining earnings. That return should be greater than the cost of capital. If it's not, it's an indication that the shareholder would be better off if those earnings were paid out as dividends. (Management on the other hand can benefit from growth regardless. After all, managing a bigger company requires a bigger salary.)

Obviously this example is extremely simplistic. Businesses can make their current capital more efficient improving earnings without much additional investment. Plus there's plenty of uncertainty in how much return one can get from future investment. But the critical thing is that there should be a reasonable belief that management can get a better return than what that capital costs as that is the only way that retaining earnings will drive value.  Otherwise they should just give shareholders the cash and let them find something productive to do with it. 

2 Comments – Post Your Own

#1) On September 17, 2012 at 5:16 PM, constructive (99.97) wrote:

Chanos is not that great. I've read that Kynikos returns are basically 0% for the last 15 years.

In my opinion he pays to much attention to operating metrics like this and not enough to valuation.  For example he's currently short HPQ which looks pretty foolish to me.

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#2) On September 19, 2012 at 12:15 PM, somrh (84.53) wrote:

I'd be curious to see Kynikos returns records.

I think it will be interesting to see how HPQ pans out. I'm sympathetic to his thesis but that may already be priced in. I don't think I'd take a position either way but I haven't done much research on it.

I actually don't think valuation is as important for shorting but that's probably an entirely different topic. Part of this is that good shorts are typically instances of detioration, fraud, accounting tricks, etc. In such cases, I think valuing a company is a bit more difficult to do. 

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