Reporting season is a time for hot takes. New information comes out, and journo’s and analysts feel like they have to say something intelligent about the result within minutes.
Share prices swing wildly as the market absorbs this new information.
One of the hottest takes I’ve heard over the past few weeks is that XYZ’s share price jumped because it declared a better-than-expected dividend.
Or that ABC’s share price fell because management cut the dividend.
I know everyone loves a dividend in this country. But it’s important to understand how dividends impact a company’s valuation and its ability to grow.
For example, if an increase in dividends comes as a result of an increase in the dividend payout ratio, and not an increase in earnings, then such a policy will be detrimental to a company’s intrinsic value calculation.
A company that retains earnings is worth more than a company that pays out most of its earnings as a dividend.
A company cannot grow without retaining some earnings (and therefore paying less out in dividends). The amount retained, and the returns on those retained earnings, will determine its growth rate.
The best way to view and assess a company’s growth is by looking at its equity per-share growth, also known as book value per-share growth.
It’s no surprise that Warren Buffett opened every one of his shareholder letters (up until 2017) with a comment on the performance of Berkshire’s ‘per-share book value’.
Given that Berkshire doesn’t pay a dividend, and therefore retains all earnings, the growth in per-share book value is a good measure of the growth of the business.
With this in mind, let’s have a look at a few Aussie stocks — one low dividend payer and one high dividend payer — to show you what I mean.
CSL for growth
The top large growth stock that comes to mind is CSL Ltd [ASX:CSL]. My data only goes back 10 years, so I’ll start from 2014. Since then, CSL’s average dividend payout ratio has been around 45%. That means it reinvests around 55% of its profits. That gives it a good basis for long-term growth.
In 2014, CSL’s book value per-share was $6.60. By the end of FY24 this book value per-share should be around $37.30. That’s 465% growth in a decade. CSL has achieved this growth via acquisitions and share buybacks.
Share buybacks reduce the number of shares on issue and therefore increase the per-share book value. Provided they’re done right, buy backs increase shareholder wealth.
What does ‘done right’ mean?
As Buffett wrote in his 2016 letter to shareholders:
‘…repurchases only make sense if the shares are bought at a price below intrinsic value. When that rule is followed, the remaining shares experience an immediate gain in intrinsic value.’
Did CSL management follow this rule? I’m not sure. It depends on how they assessed the value.
Regardless, CSL’s book value per-share has still grown strongly over the decade. So, how does this growth translate into share price growth?
Let me explain…
In 2014 (at financial year end) CSL traded at a price-to-book value of 9.4 times, or $62 per-share. That’s a high multiple. The market rewards highly profitable companies that retain earnings. They’re ‘growth’ companies.
In 2014, CSL generated an excellent return on equity (or return on book value) of 44%. When you think of the compounding effect of reinvesting earnings, and generating a high return on those reinvested earnings, you can see why the market put a high price on it.
But by 2024, CSL’s enlarged size made it difficult to maintain such a high ROE. The consensus forecast for FY24 is for ROE to hit 17%. As a result, it now trades at an implied price-to-book value of 5 times, or $286 per share.
That’s a share price increase of 360% over ten years. The reason why share price growth is lower than the growth in book value per share is that CSL now trades on a lower price-to-book multiple.
Still, when you add in $17.40 in total dividends paid, it’s a solid return of 390% over the decade.
Telstra for income
Now, let’s look at another Aussie corporate icon — Telstra [ASX:TLS]. Telstra is a well-known dividend payer. In fact, for a few years it paid out more than it earned. This meant that its book value per-share went backward!
Now, its dividend payout ratio is nearly 100%.
In 2014, Telstra’s book value per-share was $1.10. In FY24, consensus forecasts have it at $1.33. That’s about 2% growth per year. This is the low growth you should expect when a company pays out most earnings as a dividend.
So how does it fund investment in its mobile and other networks? It relies on debt. Net debt was $10.3 billion in 2014. In FY24, it’s forecast to hit $13.6 billion.
Because of Telstra’s market dominance and leverage from debt, it generates a high return on equity. At least it used to.
In 2014, ROE came in at 32%, and the shares traded on a price-to-book multiple of 4.7 times. However, profitability has declined over the past decade.
For FY24, consensus forecasts suggest ROE will come in around 13%. (This slightly understates Telstra’s profitability, as its free cashflow is higher than its accounting profit.)
Still, the point is that profitability has declined over the decade. And the market now prices Telstra’s shares on a multiple of 2.9 times book value.
How does this translate into share price growth?
Telstra’s share price closed at $5.21 on 30 June 2014. Yesterday, the price closed at $3.88. That’s a decline of 25% over 10 years. Total dividend payments over that time were $2.25, for a total return of around 18% over 10 years.
While I’m not suggesting these prices represent ‘intrinsic’ or fair value, the direction of the price over that time is consistent with how a rational investor should think about value creation and/or value destruction.
That is, if a company is paying out a high proportion of profits as a dividend, it’s going to struggle to grow per-share book value. And if profitability falls over time (as measured by ROE) the price-to-book value multiple will decline too.
That translates into a falling share price!
I hope you can see now why favouring dividend payers is not inherently a smart strategy. Sure, you want to have a bunch in your portfolio. But often what you get in income, you give up in growth. You need to be aware of this trade off.
The key is to be disciplined around valuations for both growth and income purchases, and you should do well over time.
Regards,
 |
Greg Canavan,
Editor, Fat Tail Alliance, The Insider and Fat Tail Investment Advisory
Comments