If Dividends Don’t Matter – What Does?

by Geoff Gannon

Geoff here.

There’s a good blog post over at The Interactive Investor Blog by Richard Beddard. It talks about how divdends are both everything and nothing in investing.


Dividends, Value, and Growth Can all Be Sources of Long-Term Returns

The point is that you don’t need to get a return on your investment from dividends. You can get it from someone else – in the form of capital gains – when you sell the stock. You can get it from the company directly – in the form of dividends – when they pay you cash.

For me, there are two extreme views of how investors make money in stocks.


The Pure Value Approach

You buy a stock at a discount to its value and expect to sell it when the stock price reaches that static intrinsic value sometime in the future. Your return is therefore the compound annual rate required to close the gap between price and value over the time you hold the stock.

Illustration: You pay a third of what a stock is worth today. Intrinsic value stays the same. Over the next 15 years, the stock price rises to meet intrinsic value. You sell. And make 7.6% a year over 15 years.


The Pure Growth Approach

You buy a stock and expect to sell it sometime in the future. The stock has a dynamic intrinsic value. So you hope it will be worth more in the future than it is today. Your return comes from the interaction of the price-to-value ratio you paid today and the intrinsic value growth over the time you own the stock.

Illustration: You pay three times what a stock is worth today. It grows intrinsic value 20% a year for the next 15 years. You sell. And make 11.5% a year over 15 years.

It’s worth mentioning that the item of interest to most academics, society at large, etc. should be the pure growth approach. The value approach is of most interest to practitioners. The entire investing public can benefit from holding growing companies. They can’t benefit (together) from buying businesses at one-third of their value. We can.

These are pure approaches. 

Where you buy a stock at a deep discount to its value, the company’s growth can be very poor – and you can still make money.

And when you buy a stock with very fast growth, the price you pay can be very high – and you can still make money.

Most investments fall in between. Value and growth both matter. If instead of getting a stock at one-third of its intrinsic value, a value investor buys a stock at four-fifths – he now has to worry a lot about growth.

Likewise, if a growth investor buys a stock growing 10% a year instead of 20% a year – he now has to be very careful about the price he pays for the stock.

How do we deal with stocks that fall in this gray area? They are neither deep value stocks nor incredibly fast growers. But we think they might be mispriced. And we think they might be good businesses. And we might be able to hold them for the long-term.


You Don’t Need a Present Day Dividend to Predict Future Returns

I have a pet formula of sorts I like to use. It’s not meant to be an exact calculation. It’s meant to be more of a reality check and a decomposition of a stock’s long-term return potential. Sort of like a DuPont analysis for an investment you haven’t made yet – but would like to hold for the long-term.

It goes like this…

Forever Return Potential = Cube Root of (Earnings Yield * Sales Growth * ROI)

Let me give you an illustration using Boston Beer (SAM).

Morningstar tells me Boston Beer’s 10-year average return on capital is 19%.

My rule of thumb is that if we put aside the capital structure, the normal ROI of a business is probably not far from:

0.5 * EBITDA/((Receivables + Inventory + PP&E)-(Payables + Accrued Expenses))

This is similar to Joel Greenblatt’s Magic Formula. He uses EBIT instead of EBITDA.

For Boston Beer, this approach yields a much higher estimated ROI of almost 30% for the last year or so. Capital turns at Boston Beer improved dramatically over the last decade – they more than doubled sales while holding working capital steady. My guess is that ROI really is greater than 25%. And that my little rule of thumb is probably about right here.  

However, we’ll stick with a longer-term average. Which is something like 19%.

There are a lot of ways to measure sales growth. Most people use the compound rate between two points. I prefer median year-over-year sales growth over the long-term. For the last 10 years at Boston Beer this has been about 11% a year.

Bloomberg says Boston Beer’s EV/EBITDA is 13. Again, we’ll assume economically real depreciation expenses, taxes, etc. will take half of that EBITDA before it ever becomes “owner earnings”. That means Boston Beer probably trades around 26 times owner earnings. Yes, that happens to be very close to their actual P/E ratio.

One divided by 26 is 3.85%. We’ll use that as Boston Beer’s owner earnings yield.

And now our forever return potential equation looks something like:

Forever Return Potential = Cube Root of (4 * 11 * 19)

Well, 4 times 11 times 19 is 836. And the cube root of 836 is 9.42.

A buy and hold forever return potential for Boston Beer of 9% sounds right to me.

The stock is overpriced. But it’s also a much better than average business. It will earn very high returns on capital over the next decade or so. Any growth it has will be very profitable. So, it will probably grow into its P/E of 28 times earnings and give a market matching or slightly market beating performance for truly long-term investors.


Stock Fail at Their Weakest Link – Look at the Limits on Your Returns

What’s the point of a formula like this?

An investment tends to break down at its weakest point. Boston Beer’s weakest point is price – but that’s precisely quantifiable in this case.

Growth is the variable that is hardest to predict. Remember, Boston Beer’s overall industry is not growing. Its product segment might be. But overall Beer sales are down in volume terms over the last decade.

The formula also highlights a big issue Boston Beer will face. And it’s one of critical importance to buy and hold investors.

Boston Beer grew about 11% a year in the past. It won’t grow faster than that in the future. The company’s long-term average ROI was around 20%. More recently, it’s around 30%.

There’s a gap there. A big gap. Boston Beer is currently investing in a fresh beer initiative that could require it to hold more working capital. That could help bring sales growth and returns into closer alignment. In a bad way – short-term – for shareholders but a good way for customers. A little while back, they bought a brewery. These long-term investments have masked the true extent of normal cash build at SAM.

Unless something is done, capital would grow a lot faster than sales. And I don’t think there is any way to plug this gap year after year. So assets will simply grow faster than sales – and those assets will come in cash form.

I don’t think this is an organization that wants to branch out into other things. So that means the company will probably pay a dividend in the future, or buyback stock.

Sure, it matters which option Boston Beer chooses. It matters whether they let cash pile up for a while before they start doing those things.

But, ultimately it doesn’t make a lot of sense worrying about today’s dividend yield (which is zero) when we know this is the kind of company that will one day have to pay out most of its earnings in dividends and buybacks.

It makes more sense to worry about the low earnings yield (4%) and the uses it can be put to.

Sometimes, even when a company is paying no dividend today, you can buy it with the knowledge that return of capital will be as important as return on capital over the next couple decades.

That’s the case with Boston Beer.

And a good way to look at investments like this is to focus on:

  • Earnings Yield
  • Sales Growth
  • Return on Investment

And not just dividend yield.

Because the capacity to pay a dividend is almost as important as actual payment of that dividend. In fact, in a high return business – there’s no good reason to prefer a dividend.