We get questions like these all the time, so decided to reproduce the discussion from our private course group into this blog post. I have not worried about the look and feel and have just reproduced my response below…
The expected long term future return of any business comprises 3 factors: 1. The earnings growth rate (which captures the rate of growth of the intrinsic value of the business) 2. The % return in form of dividends/buybacks 3. The multiple expansion (when you buy a business at a low P/E and when that multiple expands over time)
Now let’s park the item 3 for the moment and treat it like a bonus…let’s assume that the P/E multiple remains same over the years. Which means, long term return of a share holder would depend on The EPS growth + Dividend yield. You would notice…here instead of earnings growth, I mentioned EPS growth. The effect of the share buy-backs also boost ‘EPS’ by reducing the number of outstanding shares, so to capture this effect of the buy-backs we use EPS growth.
Now in the example, you mentioned 1% rev. growth…what you need to estimate is what % earnings growth this will translate into…Let’s assume that the business is growing its earnings also @1%/year (so not really growing the earnings as it is hardly reinvesting any capital in the business). The business is returning most of the capital to the shareholders via dividends and is also buying back some shares…maybe the business is reinvesting just 10% of earnings and has a payout ratio of 90%…the 10% of earnings is reinvested at a ROIC of 10%..so this leads to an earnings growth of just 1% (10% Reinvestment X 10% ROIC)
Let’s say, the buybacks translate into reduction of share count by a couple of % points each year…so this roughly translates into a ~ 3% eps growth…1% from the earnings growth and 2% form buybacks
Let’s assume that the current dividend yield is 4%.
Now if we assume the P/E stays the same over time, then in the Long term we can expect an approximate return to the share holders of 3% (EPS growth) +4% (Dividend yield) = 7% ….in it’s current form, if I am ok with that 7% return, and if I like this business, then I could choose to buy this business right away. This is equivalent to buying the business at a price which is same as the IV arrived at using a DCF with a discount rate of 7%. Let’s say the the Current P/E ratio is 14
However let’s assume a different scenario….that I really like the business (hypothetically :-), but at the same time, I have decided that I will not invest in anything below a 15% expected return….so in that case, if I am doing a DCF (which is not even required because a back of envelope calculation will give me all the answers), then I will use that 15% as my opportunity cost and use a 15% discount rate…so that will of course give me a much lower value for the Intrinsic Value of this business. This means, to buy the same business and to be able to get a 15% return, I need to only buy it at a much lower price, equivalent to a much lower P/E (maybe a PE of only 7X) , as the operating characteristic of this business are unlikely to change much. I would have a chance of getting my required 15% return, only if at some point the PE expands to compensate me with the extra 8%. So out of this 15% return, the 3% comes from the EPS growth, 4% from the Dividend yield….but the balance 8% has to come from the P/E expansion over time (The 3rd factor, which we had parked above). Say if I managed to buy it at a very low P/E of 7X, and if I hold this business for a 9-10 year period, over which the P/E expands to the normal level of 14X, this is equivalent to the additional 8% CAGR.
However we need to understand that it is difficult to predict the P/E expansion, as that depends on human emotions… and hence personally I would never rely on that. I would consider that as a bonus. That is the reason when we look for businesses we try to find the ones that provide us our required 15% preferably from the Earnings growth along…or maybe from Earnings Growth + Dividend yield
Which means buying the business @ the normal 14X PE gives me a 7% return (EPS growth + Dividend yield), but buying it for 7X PE, could give me a 15% return over a 9 year holding period, if the P/E expands by a CAGR of 8%…the final return could change based on how each of these 3 components change.
This is just a back of the envelope explanation of the various linkages…but don’t be too hung up with the numbers in the example. Hope this to an extent explains the relationships between the terms EPS growth, Payout Ratio, Dividend Yield, Reinvestment Rate, ROIC, P/E ratio, Discount Rate, Intrinsic Value calculation etc, and how these linkages translate into the long term returns of the shareholders.
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