What Is The Monetary Cost of Stock-Based Compensation?

Confused by stock-based compensation? Here is how investors can account for SBC when calculating intrinsiic value.

It is common today for companies to exclude stock-based compensation (SBC) when reporting “adjusted” earnings.

In management’s eyes, SBC expense is not a cash outflow and is excluded when reporting adjusted earnings. But don’t let that fool you. SBC is a real expense for shareholders. It increases a company’s outstanding share count and reduces future dividends per share.

I’ve thought about SBC quite a bit in the last few months. One thing I noticed is that investors often do not properly account for it. There are a couple of different scenarios that I believe should lead to investors using different methods to account for SBC.

Scenario 1: Offsetting dilution with buybacks

The first scenario is when a company is both buying back shares and issuing shares to employees as SBC. The easiest and most appropriate way to account for SBC in this situation is by calculating how much the company spent to buy back the stock that vested in the year.

Take the credit card company Visa (NYSE: V) for example. In its FY2022 (fiscal year ended 30 September 2022), 2.2 million restricted stock units (RSUs) were vested and given to Visa employees. At the same time, Visa bought back 56 million shares at an average price of US$206 per share. In other words, Visa managed to buy back all the shares that were vested, and more.

We can calculate the cash outlay that Visa spent to offset the dilution from the grants of RSUs by multiplying the number of grants by the average price it paid to buy back its shares. In Visa’s case, the true cost of the SBC was around US$453 million (2.2 million RSUs multiplied by average price of US$206).

We can then calculate how much free cash flow (FCF) was left over that could be returned to shareholders by deducting US$453 million from Visa’s FCF. In FY2022, this FCF was US$17.4 billion.

Scenario 2: No buybacks!

On the other hand, when a company is not offsetting dilution with buybacks, it becomes trickier to account for SBC.

Under GAAP accounting, SBC is reported based on the company’s stock price at the time of the grant. But in my view, this is a severely flawed form of accounting. Firstly, unless the company is buying back shares, the stock price does not translate into the true cost of SBC. Second, even if the stock price was a true reflection of intrinsic value, the grants may have been made years ago and the underlying value of each share could have changed significantly since then.

In my view, I think the best way to account for SBC is by calculating how SBC is going to impact future dividend payouts to shareholders. This is the true cost of SBC.

Let’s use Okta Inc (NASDAQ: OKTA) as an example. In Okta’s FY2023 (fiscal year ended 31 January 2023), 2.6 million RSUs were vested and the company had 161 million shares outstanding at the end of the year (after dilution). This means that the RSUs vested led to a 1.7% rate of dilution. Put another way, all future dividends per share for Okta will be reduced by around 1.7%. Although the company is not paying a dividend yet, RSUs vested should lead to a reduction in the intrinsic value per share by 1.7%.

More granularly, I did a simple dividend discount model. I made certain assumptions around free cash flow growth and future dividend payout ratios. Using those assumptions and a 12% discount rate, I found that Okta’s intrinsic value was around US$12.5 billion.

With an outstanding share count of 161 million, Okta’s stock was worth US$77.63 each. Before dilution, Okta had 158.4 million shares and each share was worth US$78.91. The cost of dilution was around US$1.28 per share or US$201 million dollars.

Scenario 3: How about options?

In the two scenarios above, I only accounted for the RSU portion of the SBC. Both Okta and Visa also offer employees another form of SBC: Options.

Options give employees the ability to buy stock in a company in the future at a predetermined price. Unlike RSUs, the company receives cash when an option is exercised.

In this scenario, there is a cash inflow but an increase in share count. The best way to account for this is by calculating the drop in intrinsic value due to the dilution but offsetting it by the amount of cash the company receives.

For instance, Okta employees exercised 1.4 million options in FY2023 at a weighted average share price of US$11.92. Recall that we calculated our intrinsic value of shares after dilution to be US$78.91. Given the same assumptions, the cost of these options was US$66.99 per option, for a total cost of US$93.7 million.

Key takeaways

SBC can be tricky for investors to account for. Different scenarios demand different analysis methods.

When a company is buying back shares, the amount spent on offsetting dilution is the amount that can not be used as dividends. This is the cost to shareholders. On the other hand, when no buybacks are done, a company’s future dividends per share is reduced as the number of shares grows.

Ultimately, the key thing to take note of is how SBC impacts a company’s future dividends per share. By sticking to this simple principle, we can deduce the best way to account for SBC.

Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life. I have a vested interest in Okta and Visa. Holdings are subject to change at any time.

How Bad is Zoom’s Stock-Based Compensation?

On the surface, the rising stock based compensation for Zoom looks bad. But looking under the hood, the situation is not as bad as it looks.

There seems to be a lot of concern surrounding Zoom’s rising stock-based compensation (SBC).

In its financial years 2021, 2022 and 2023, Zoom recorded SBC of US$275 million, US$477 million and US$1,285 million, respectively. FY2023 was perhaps the most worrying for investors as Zoom’s revenue essentially flat-lined while its SBC increased by more than two-fold.

But as mentioned in an earlier article, GAAP accounting is not very informative when it comes to SBC. When companies report SBC using GAAP accounting, they record the amount on the financial statements based on the share price at the time of the grant. A more informative way to look at SBC would be from the perspective of the actual number of shares given out during the year.

In FY2021, 2022 and 2023, Zoom issued 0.6 million, 1.8 million and 4 million restricted stock units (RSUs), respectively. From that point of view, it seems the dilution is not too bad. Zoom had 293 million shares outstanding as of 31 January 2023, so the 4 million RSUs issued resulted in only 1.4% more shares.

What about down the road?

The number of RSUs granted in FY2023 was 22.1 million, up from just 3.1 million a year before. The big jump in FY2023 was because the company decided to give a one-time boost to existing employees.

However, this does not mean that Zoom’s dilution is going to be 22 million shares every year from now. The number of RSUs granted in FY2023 was probably a one-off grant that will likely not recur and these grants will vest over a period of three to four years.

If we divide the extra RSUs given in FY2023 by their 4-year vesting schedule, we can assume that around 8 million RSUs will vest each year. This will result in an annual dilution rate of 2.7% based on Zoom’s 293 million shares outstanding as of 31 January 2023.

Bear in mind: Zoom guided for a weighted diluted share count of 308 million for FY2024. This diluted number includes 4.8 million in unexercised options that were granted a number of years ago. Excluding this, the number of RSUs that vest will be around 10 million and I believe this is because of an accelerated vesting schedule this year.

Cashflow impact

Although SBC does not result in a cash outflow for companies, it does result in a larger outstanding share base and consequently, lower free cash flow per share.

But Zoom can offset that by buying back its shares. At its current share price of US$69, Zoom can buy back 8 million of its shares using US$550 million. Zoom generated US$1.5B in free cash flow if you exclude working capital changes in FY2023. If it can sustain cash generation at this level, it can buy back all its stock that is issued each year and still have around US$1 billion in annual free cash flow left over for shareholders.

And we also should factor in the fact that in most companies, due to employee turnover, the RSU forfeiture rate is around 20% or more, which will mean my estimate of 8 million RSUs vesting per year for Zoom could be an overestimate. In addition, Zoom reduced its headcount by 15% in February this year, which should lead to more RSU forfeitures and hopefully fewer grants in the future.

Not as bad as it looks

GAAP accounting does not always give a complete picture of the financial health of a business. In my view, SBC is one of the most significant flaws of GAAP accounting and investors need to look into the financial notes to better grasp the true impact of SBC.

Zoom’s SBC numbers seem high. But when zooming in (pun intended), the SBC is not as bad as it looks. In addition, with share prices so low, it is easy for management to offset dilution with repurchases at very good prices. However, investors should continue to monitor share dilution over time to ensure that management is fair to shareholders.

When Share Buybacks Lose Their Power

Apple’s share buybacks have greatly benefited shareholders in the past. But with share prices much higher, buybacks may be less powerful.

Share buybacks can be a powerful tool for companies to boost their future earnings per share. By buying back shares, a company’s future earnings can now be shared between fewer shares, boosting the amount each shareholder can get.

Take Apple for example. From 2016 to 2022, the iPhone maker’s net income increased by 118%, or around 14% annualised. That’s pretty impressive. But Apple’s earnings per share (EPS) outpaced net income growth by a big margin: EPS advanced by 193%, or 19.6% per year.

The gap exists because Apple used share buybacks to decrease its share count. Its outstanding share count dropped by around 30%, or an annualised rate of close to 5.7%, over the same period.

But the power of buybacks is very much dependent on the price at which they are conducted. If a company’s share price represents a high valuation, earnings per share growth from buybacks will be less, and vice versa.

Valuations matter

To compare how buybacks lose their effectiveness when valuations rise, let’s examine a simple illustration. There are two companies, A and B, that both earn a $100 net profit every year and have 100 shares outstanding. These give them both earnings per share of $1. Let’s say Company A’s share price is $10 while Company B’s is at $20. The two companies also use all their profits in year 1 to buy back their shares.

Companies A and B would end the year with 90 and 95 shares outstanding, respectively. From Year 2 onwards, Company A’s earnings per share will be $1.11, or an 11% increase. Company B on the other hand, only managed to increase its earnings per share to $1.052, or 5.2%.

Buybacks are clearly much more effective when the share prices, and thus the valuation, is lower.

The case of Apple

As I mentioned earlier, Apple managed to decrease its share count by 30% over the last six years or 5.7% per year. A 30% decrease in shares outstanding led to a 42% increase in EPS*.

Apple was able to decrease its share count so significantly during the last six years because its share price was trading at relatively low valuations. Apple also used almost all of its free cash flow that it generated over the last six years to buy back shares. The chart below shows Apple’s price-to-earnings multiples from 2016.

Source: TIKR

From 2016 to 2019, Apple’s trailing price-to-earnings (PE) ratio ranged from 10 to 20. But since then, the PE ratio has increased and now sits around 30.

In the last 6 years – from 2016 to 2022 – Apple was able to reduce its share count by 30% or 5.7% a year. But with its PE ratio now at close to 30, the impact of Apple’s buybacks will not be as significant. If Apple continues to use 100% of its free cash flow to buy back shares, it will reduce its share count only by around 3.3% per year. Although that’s a respectable figure, it doesn’t come close to what Apple achieved in the 6 years prior.

At an annual reduction rate of 3.3%, Apple’s share count will only fall by around 18% over six years, compared to the 30% seen from 2016 to 2022. This will increase Apple’s earnings per share by around 22% versus the actual 42% clocked in the past six years.

In closing

Apple is a great company that has rewarded shareholders multiple folds over the last few decades. In addition to growing its business, timely buybacks have also contributed to the fast pace of Apple’s earnings per share growth.

Although I believe Apple will likely continue to post stellar growth in the coming years with the growth of its services business and its potential in emerging markets, growth from buybacks may not be as powerful as it used to be.

When analysing the power of buybacks, shareholders should monitor the valuation of the stock and assess whether the buybacks are worthwhile for shareholders.

*(1/1-0.3)

Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life. I have a vested interest in Apple. Holdings are subject to change at any time.

What Causes Stock Prices To Rise?

A company can be valued based on its future cash flows. Dividends, as cashflows to shareholders, should therefore drive stock valuations.

I recently wrote about why dividends are the ultimate driver of stock valuations. Legendary investor Warren Buffett once said: “Intrinsic value can be defined simply as the discounted value of cash that can be taken out of business during its remaining life.”

And dividends are ultimately the cash that is taken out from a business over time. As such, I consider the prospect of dividends as the true driver of stock valuations.

But what if a company will not pay out a dividend in my lifetime?

Dividends in the future

Even though we may never receive a dividend from a stock, we should still be able to make a gain through stock price appreciation.

Let’s say a company will only start paying out $100 a share in dividends 100 years from now and that its dividend per share will remain stable from then. An investor who wants to earn a 10% return will be willing to pay $1000 a share at that time.

But it is unlikely that anyone reading this will be alive 100 years from now. That doesn’t mean we can’t still make money from this stock.

In Year 99, an investor who wants to make a 10% return will be willing to pay $909 a share as they can sell it to another investor for $1000 in Year 100. That’s a 10% gain.

Similarly, an investor knowing this, will be willing to pay $826 in Year 98, knowing that another buyer will likely be willing to pay $909 to buy it from him in a year. And on and on it goes.

Coming back to the present, an investor who wants to make a 10% annual return should be willing to pay $0.07 a share. Even though this investor will likely never hold the shares for 100 years, in a well-oiled financial system, the investor should be able to sell the stock at a higher price over time.

But be warned

In the above example, I assumed that the financial markets are working smoothly and investors’ required rate of return remained constant at 10%. I also assumed that the dividend trajectory of the company is known. But reality is seldom like this.

The required rate of return may change depending on the risk-free rate, impacting what people will pay for the stock at different periods of time. In addition, uncertainty about the business may also lead to stock price fluctuations. Furthermore, there may even be mispricings because of misinformation or simply irrational behaviour of buyers and sellers of the stock. All of these things can lead to wildly fluctuating stock prices.

So even if you do end up being correct on the future dividend per share of the company, the valuation trajectory you thought that the company will follow may end up well off-course for long periods. The market may also demand different rates of return from you leading to the market’s “intrinsic value” of the stock differing from yours.

The picture below is a sketch by me (sorry I’m not an artist) that illustrates what may happen:

The smooth line is what your “intrinsic value” of the company looks like over time. But the zig-zag line is what may actually happen.

Bottom line

To recap, capital gains can be made even if a company doesn’t pay a dividend during our lifetime. But we have to be wary that capital gains may not happen smoothly.

Shareholders, even if they are right about a stock’s future dividend profile, must be able to hold the stock through volatile periods until the stock price eventually reaches above or at least on par with our intrinsic value to make our required rate of return.

You may also have noticed from the chart that occasionally stocks can go above your “intrinsic value” line (whatever rate of return you are using). If you bought in at these times, you are unlikely to make a return that meets your required rate.

To avoid this, we need to buy in at the right valuation and be patient enough to wait for market sentiment to converge to our intrinsic value over time to make a profit that meets our expectations. Patience and discipline are, hence, key to investment success. And of course, we also need to predict the dividend trajectory of the company somewhat accurately.

Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life. I do not have a vested interest in any stocks mentioned. Holdings are subject to change at any time.

How Do Changing Assumptions Impact Intrinsic Values?

Are stock price movements due to new information justified? Here’s one way to find out.

It is not uncommon to see stock prices gyrate wildly during earnings season. A small earnings beat and the stock goes up 10% or even 20%. An earnings miss and the stock is down double digits after hours.

Are these stock price movements justified? Has the intrinsic value of the stock really changed that much? In this article, I look at how a change in assumptions about a company’s cash flow can affect the intrinsic value of the stock.

I take a look at what effects changing assumptions to a company’s cash flow have on the intrinsic value of the stock.

When long-term assumptions are slashed

Let’s start by analysing a stock that has its long-term assumptions slashed. This should have the biggest impact on intrinsic value compared to just a near-term earnings miss.

Suppose Company A is expected to dish out $1 in dividends every year for 10 years before it closes down in year 10 and liquidates for $5 a share. The liquidation value is paid out to shareholders as a special dividend in year 10. The table below shows the dividend schedule and the calculation of the intrinsic value of the stock today using a 10% discount rate.

Year	Dividend	Net present value
Now	$0.00	$0.00
Year 1	$1.00	$0.91
Year 2	$1.00	$0.83
Year 3	$1.00	$0.75
Year 4	$1.00	$0.68
Year 5	$1.00	$0.62
Year 6	$1.00	$0.56
Year 7	$1.00	$0.51
Year 8	$1.00	$0.47
Year 9	$1.00	$0.42
Year 10	$6.00	$2.31
Sum	$15.00	$8.07

The intrinsic value in this case is $8.07.

But what if expectations for Company A are slashed? The dividend schedule is now expected to drop 10% to 90 cents per share for the next 10 years. The liquidation value is also cut by 10% to $4.50. The table below illustrates the new dividend expectation and the new intrinsic value of the stock.

Year	Dividend	Net present value
Now	$0.00	$0.00
Year 1	$0.90	$0.82
Year 2	$0.90	$0.74
Year 3	$0.90	$0.68
Year 4	$0.90	$0.61
Year 5	$0.90	$0.56
Year 6	$0.90	$0.51
Year 7	$0.90	$0.46
Year 8	$0.90	$0.42
Year 9	$0.90	$0.38
Year 10	$5.40	$2.08
Sum	$13.50	$7.27

Understandably, the intrinsic value drops 10% to $7.27 as all future cash flows are now 10% less. In this case, if the stock was trading close to the initial $8.07 per share intrinsic value, then a 10% decline in the stock price can be considered justified.

When only short-term cash flows are impacted

But most of the time, expectations for a company should not change so drastically. An earnings miss may lead to expectations of lower dividends for the next couple of years but does not impact dividend projections for later years.

For instance, let’s say the dividend projection for Company A above is cut by 10% for Year 1 but returns to $1 per share in Year 2 onwards and the liquidation value at the end of Year 10 is still $5. The table shows the new expected dividend schedule and the intrinsic value of the stock.

Year	Dividend	Net present value
Now	$0.00	$0.00
Year 1	$0.90	$0.82
Year 2	$1.00	$0.83
Year 3	$1.00	$0.75
Year 4	$1.00	$0.68
Year 5	$1.00	$0.62
Year 6	$1.00	$0.56
Year 7	$1.00	$0.51
Year 8	$1.00	$0.47
Year 9	$1.00	$0.42
Year 10	$6.00	$2.31
Sum	$14.90	$7.98

In this case, the intrinsic value drops to $7.98 from $8.07. Only a small decline in the stock price is warranted if the stock was initially trading close to its $8.07 intrinsic value since the decline in intrinsic value is only minimal.

Delaying cash flows to the shareholder

Expectations can also change about the timing of cash flows paid to shareholders. This will also impact the intrinsic value of a stock.

For the same company above, instead of dividends per share declining, the dividends are paid out one year later than expected. The table below shows the new expected dividend schedule and the present value of the cash flows.

Year	Dividend	Net present value
Now	$0.00	$0.00
Year 1	$0.00	$0.00
Year 2	$1.00	$0.83
Year 3	$1.00	$0.75
Year 4	$1.00	$0.68
Year 5	$1.00	$0.62
Year 6	$1.00	$0.56
Year 7	$1.00	$0.51
Year 8	$1.00	$0.47
Year 9	$1.00	$0.42
Year 10	$1.00	$0.39
Year 11	$6.00	$2.10
Sum	$15.00	$5.24

As you can see this has a bigger impact on intrinsic value. The intrinsic value of the stock drops to $5.24 from $8.07. But this is a pretty extreme example. We have delayed all future cash flows by one year. In most cases, our expectations may not change so drastically. For instance, Year 1’s dividend may just be pushed to Year 2. The table below illustrates this new scenario.

Year	Dividend	Net present value
Now	$0.00	$0.00
Year 1	$0.00	$0.00
Year 2	$2.00	$1.65
Year 3	$1.00	$0.75
Year 4	$1.00	$0.68
Year 5	$1.00	$0.62
Year 6	$1.00	$0.56
Year 7	$1.00	$0.51
Year 8	$1.00	$0.47
Year 9	$1.00	$0.42
Year 10	$6.00	$2.31
Sum	$15.00	$7.99

In this case, the intrinsic value only drops by a few cents to $7.99.

Conclusion

A change in expectations for a company has an impact on intrinsic value. But unless the expectations have changed dramatically, the change in intrinsic value is usually small.

Fluctuations in stock prices are more often than not overreactions to new information that the market is prone to make. Most of the time, the new information does not change the expectations of a company drastically and the stock price movements can be considered unjustified. This is the case if the stock price is trading close to its original intrinsic value to begin with.

But bear in mind, this works both ways. Stock price pops can also be considered unjustified depending on the situation. As investors, we can use any mispricing of stocks to earn a good long-term return.

Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life. I have no vested interest in any companies mentioned. Holdings are subject to change at any time.

How To Find The Intrinsic Value of a Stock At Different Points in Time

intrinsic value is the sum of all future cash flows discounted to the present, but it can also change over the course of time.

A company’s intrinsic value is the value of the sum of future cash flows to the shareholder discounted to the present day.

But the intrinsic value of a company is not static. It moves with time. The closer we get to the future cash flows, the more an investor should be willing to pay for the company.

In this article, I will run through (1) how to compute the intrinsic value of a company today, (2) how to plot the graph of the intrinsic value, and (3) what to do with intrinsic value charts.

How to calculate intrinsic value

Simply put, intrinsic value is the sum of all future cash flows discounted to the present.

As shareholders of a company, the future cash flow is all future dividends and the proceeds we can collect when we eventually sell our shares in the company.

To keep things simple, we should assume that we are holding a company to perpetuity or till the business closes down. This will ensure we are not beholden to market conditions that influence our future cash flows through a sale. We, hence, only need to concern ourselves with future dividends.

To calculate intrinsic value, we need to predict the amount of dividends we will collect and the timing of that dividend.

Once we figure that out, we can discount the dividends to the present day.

Let’s take a simple company that will pay $1 a share for 10 years before closing down. Upon closing, the company pays a $5 dividend on liquidation. Let’s assume we want a 10% return. The table below shows the dividend schedule, the value of each dividend when discounted to the present day and the total intrinsic value of the company now.

Year	Dividend	Net present value
Now	$0.00	$0.00
Year 1	$1.00	$0.91
Year 2	$1.00	$0.83
Year 3	$1.00	$0.75
Year 4	$1.00	$0.68
Year 5	$1.00	$0.62
Year 6	$1.00	$0.56
Year 7	$1.00	$0.51
Year 8	$1.00	$0.47
Year 9	$1.00	$0.42
Year 10	$6.00	$2.31
Sum	$15.00	$8.07

As you can see, we have calculated the net present value of each dividend based on how far in the future we will receive them. The equation for the net present value is: (Dividend/(1+10%)^(Years away).

The intrinsic value is the sum of the net present value of all the dividends. The company in this situation has an intrinsic value of $8.07.

Intrinsic value moves

In the above example, we have calculated the intrinsic value of the stock today. But the intrinsic value moves with time. In a year, we will have collected $1 in dividends which will lower our intrinsic value. But at the same time, we will be closer to receiving subsequent dividends.

The table below shows the intrinsic value immediately after collecting our first dividend in year 1.

Year	Dividend	Net present value
Now	$0.00	$0.00
Year 1	$1.00	$0.91
Year 2	$1.00	$0.83
Year 3	$1.00	$0.75
Year 4	$1.00	$0.68
Year 5	$1.00	$0.62
Year 6	$1.00	$0.56
Year 7	$1.00	$0.51
Year 8	$1.00	$0.47
Year 9	$6.00	$2.54
Sum	$14.00	$7.88

There are a few things to take note of.

First, the sum of the remaining dividends left to be paid has dropped to $14 (from $15) as we have already collected $1 worth of dividends.

Second, the intrinsic value has now dropped to $7.88.

We see that there are two main effects of time.

It allowed us to collect our first dividend payment of $1, reducing future dividends. That has a net negative impact on the remaining intrinsic value of the stock. But we are also now closer to receiving future dividends. For instance, the big payout after year 10 previously is now just 9 years away.

The net effect is that the intrinsic value dropped to $7.88. We can do the same exercise over and over to see the intrinsic value of the stock over time. We can also plot the intrinsic values of the company over time.

Notice that while intrinsic value has dropped, investors still manage to get a rate of return of 10% due to the dividends collected.

When a stock doesn’t pay a dividend for years

Often times a company may not pay a dividend for years. Think of Berkshire Hathaway, which has not paid a dividend in decades.

The intrinsic value of Berkshire is still moving with time as we get closer to the dividend payment. In this scenario, the intrinsic value simply rises as we get closer to our dividend collection and there is no net reduction in intrinsic values through any payment of dividends yet.

Take for example a company that will not pay a dividend for 10 years. After which, it begins to distribute a $1 per share dividend for the next 10 years before closing down and pays $5 a share in liquidation value.

Year	Dividend	Net present value
Now	0	$0.00
Year 1	0	$0.00
Year 2	0	$0.00
Year 3	0	$0.00
Year 4	0	$0.00
Year 5	0	$0.00
Year 6	0	$0.00
Year 7	0	$0.00
Year 8	0	$0.00
Year 9	0	$0.00
Year 10	$0.00	$0.00
Year 11	$1.00	$0.35
Year 12	$1.00	$0.32
Year 13	$1.00	$0.29
Year 14	$1.00	$0.26
Year 15	$1.00	$0.24
Year 16	$1.00	$0.22
Year 17	$1.00	$0.20
Year 18	$1.00	$0.18
Year 19	$1.00	$0.16
Year 20	$6.00	$0.89
Sum	$15.00	$3.11

The intrinsic value of such a stock is around $3.11 at present. But in a year’s time, as we get closer to future dividend payouts, the intrinsic value will rise.

A simple way of thinking about it is that in a year’s time, the intrinsic value will have risen 10% to meet our 10% discount rate or required rate of return. As such, the intrinsic value will be $3.42 in one year. The intrinsic value will continue to rise 10% each year until we receive our first dividend payment in year 10.

The intrinsic value curve will look like this for the first 10 years:

The intrinsic value is a smooth curve for stocks that do not yet pay a dividend.

Using intrinsic value charts

Intrinsic value charts can be useful in helping investors know whether a stock is under or overvalued based on your required rate of return.

Andrew Brenton, CEO of Turtle Creek Asset Management whose main fund has produced a 20% annualised return since 1998 (as of December 2022), uses his estimate of intrinsic values to make portfolio adjustments.

If a stock goes above his intrinsic value, it means that it will not be able to earn his required rate of return. In that case, he lowers his portfolio weighting of the stock and vice versa.

While active management of the portfolio using this method can be rewarding as in the case of Turtle Creek, it is also fairly time-consuming.

Another way to use intrinsic value charts is to use it to ensure you are getting a good entry price for your stock. If a stock trades at a price above your intrinsic value calculations, it may not be able to achieve your desired rate of return.

Final thoughts

Calculating the intrinsic value of a company can help investors achieve their return goals and ensure that they maintain discipline when investing in a company.

However, there are limitations.

For one, intrinsic value calculations require an accurate projection of future payments to the shareholder. In many cases, it is hard for investors to predict with accuracy and confidence. We have to simply rely on our best judgement.

We are also often limited by the fact that we may not hold stock to perpetuity or its natural end of life and liquidation. In the case that we need to sell the stock prematurely, we may be beholden to market conditions at the time of our sale of the stock.

It is also important to note that intrinsic value is not the same for everyone. I may be willing to attribute a higher intrinsic value to a company if my required rate of return is lower than yours. So each individual investor has to set his own target return to calculate intrinsic value.

Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life. I do not have a vested interest in any stocks mentioned. Holdings are subject to change at any time.

What’s Your Investing Edge?

Whats your investing edge? That’s the question many investors find themselves asking when building a personal portfolio. Here are some ways to gain an edge.

Warren Buffett probably has the most concise yet the best explanation of how to value a stock. He said: “Intrinsic value can be defined simply: it is the discounted value of the cash that can be taken out of a business during its remaining life.”

This is how all stocks should theoretically be valued. In a perfect market where cash flows are certain and discount rates remain constant, all stocks should provide the same rate of return.

But this is not the case in the real world. Stocks produce varying returns, allowing investors to earn above-average returns.

Active stock pickers have developed multiple techniques to try to obtain these above-average returns to beat the indexes. In this article, I’ll go through some investing styles, why they can produce above-average returns, and the pros and cons of each style.

Long-term growth investing

One of the more common approaches today is long-term growth investing. But why does long-term investing outperform the market?

The market underestimates the growth potential

One reason is that market participants may underestimate the pace or durability of the growth of a company.

Investors may not be comfortable projecting that far in the future and often are only willing to underwrite growth over the next few years and may assume high growth fades away beyond a few years.

While true for most companies, there are high-quality companies that are exceptions. if investors can find these companies that beat the market’s expectations, they can achieve better-than-average returns when the growth materialises. The chart below illustrates how investors can potentially make market-beating returns.

Let’s say the average market’s required rate of return is 10%. The line at the bottom is what the market thinks the intrinsic value is based on a 10% required return. But the company exceeds the market’s expectations, resulting in the stock price following the middle line instead and a 15% annual return.

The market underwrites a larger discount rate

Even if the market has high expectations for a company’s growth, the market may want a higher rate of return as the market is uncertain of the growth playing out. The market is only willing to pay a lower price for the business, thus creating an opportunity to earn higher returns.

The line below is what investors can earn which is more than the 10% return if the market was more confident about the company.

Deep value stocks

Alternatively, another group of investors may prefer to invest in companies whose share prices are below their intrinsic values now.

Rather than looking at future intrinsic values and waiting for the growth to play out, some investors simply opt to buy stocks trading below their intrinsic values and hoping that the company’s stock closes the gap. The chart below illustrates how this will work.

The black line is the intrinsic value of the company based on a 10% required return. The beginning of the red line is where the stock price is at. The red line is what investors hope will happen over time as the stock price closes the gap with its intrinsic value. Once the gap closes, investors then exit the position and hop on the next opportunity to repeat the process.

Pros and cons

All investing styles have their own pros and cons.

Underappreciated growth
For long-term investing in companies with underappreciated growth prospects, investors need to be right about the future growth of the company. To do so, investors must have a keen understanding of the business background, growth potential, competition, potential that the growth plays out and why the market may be underestimating the growth of the company.

This requires in-depth knowledge of the company and requires conviction in the management team being able to execute better than the market expects of them.

Underwriting larger discount rates
For companies that the market has high hopes for but is only willing to underwrite a larger discount rate due to the uncertainty around the business, investors need to also have in-depth knowledge of the company and have more certainty than the market that the growth will eventually play out.
Again, this may require a good grasp of the business fundamentals and the probability of the growth playing out.
Undervalued companies
Thirdly, investors who invest in companies based on valuations being too low now, also need a keen understanding of the business. Opportunities can arise due to short-term misconceptions of a company but investors must have a differentiated view of the company from the rest of the market.
A near-term catalyst is often required for the market to realise the discrepancy. A catalyst can be in the form of dividend increases or management unlocking shareholder value through spin-offs etc. This style of investing often requires more hard work as investors need to identify where the catalyst will come from. Absent a catalyst, the stock may remain undervalued for long periods, resulting in less-than-optimal returns. In addition, new opportunities need to be found after each exit.

What’s your edge?

Active fundamental investors who want to beat the market can use many different styles to beat the market. While each style has its own limitations, if done correctly, all of these techniques can achieve market-beating returns over time.

Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life. I do not have a vested interest in any stocks mentioned. Holdings are subject to change at any time.

Forget Profits or Free Cash Flow – Dividends Are What Really Matters!

Profits and free cash flow are nice metric to have as a company. But they may be reinvested. What really matters is what cash can be eventually distributed.

Investors often talk about profits and free cash flow. I’m no exception. If you look at the archive of articles on this blog, you will find that I have written about both of these subjects numerous times.

So why am I saying that profits and free cash flow are not what really matter and that dividends are what ultimately matters most?

Well, that’s because an asset should be valued based on the cash flow that the asset can produce for the asset holder. In the case of stocks, dividends are the only cash flow you receive as a long-term shareholder.

Business profits may not end up in our pockets

Although profits or free cash flow that a business earns can theoretically be returned to the shareholder, the truth is that, more often than not, they aren’t. Companies may want to retain a portion or all of that cash flow for reinvestment in the business, acquisitions, or buybacks.

Let’s take a look at a simple example.

Company A is a profitable business. It generates $1 in free cash flow in year one. The company does not want to pay a dividend. Instead, it reinvests that $1 to generate 10% more cash flows the subsequent year. It keeps reinvesting its profits each year for 5 years. Only after Year 5 does Company A decide that it will start to return all its free cash flow to shareholders as dividends. Its free cash flow per year stagnates after Year 5. Here is what Company A’s annual free cash flow and dividend per share look like:

Company B, on the other hand, produces $0 in free cash flow in Years 1 to 5. But in Year 6, it starts to generate $1.61 in free cash flow per share and pays all of that out as dividends each year. Like Company A, its growth stagnates after Year 5.

Here is what Company B’s annual free cash flow and dividend per share look like:

Which company is worth more? Neither. They are worth the same. That is because the cash flow received by the shareholders is equal.

Free cash flow and profits do not reflect all costs

If the above example left you slightly confused, maybe you can think of it like this. A company may be generating free cash flow but uses all that cash to grow through acquisitions or conduct share buybacks. Another company may be using its cash from operations to build more capacity to drive growth. The cash spent here are capital expenses which lower free cash flow*.

The first company may appear to be generating a lot of free cash flow but that cash is being spent on buybacks and acquisitions. The second company has no free cash flow but that’s because its investments are deducted before calculating free cash flow. Both these companies end up with no cash that year that can be returned to shareholders even though one is generating free cash flow and the other one is not. The difference lies in where these expenses/investments are recorded.

Capital expenses are deducted in the calculation of free cash flow but cash acquisitions of another company or buybacks usually are not. Correspondingly, a company that is spending heavily on marketing for growth may show up with no operating cash flow at all and consequently no free cash flow. Ultimately, it does not matter how the company invests or whether free cash flow appears on the financial statements. What really matters is how much cash the company can eventually return to shareholders as dividends, now or in the future.

Although it is true that dividends will eventually come from the free cash flow that a company produces, it is not always true that the free cash flow produced in any given year will lead to dividends.

A brief comment on buybacks

This discussion would not be complete without a short discussion on where buybacks fit into the grand scheme of things. Companies often declare that they have “returned” cash to shareholders through buybacks.

However, this cash is only returned to shareholders who actually sell their stock to the company. What do long-term shareholders who do not sell their shares to the company get? They certainly do not receive any cash.

I count buybacks as a form of investment that the company makes. Buybacks increase a company’s free cash flow per share by reducing the outstanding share count. Long-term shareholders benefit as future dividends are now split among fewer shares.

Given this, I do not count buybacks as cash that is “returned” to the long-term shareholder. Instead, I count it as an investment that drives free cash flow per share growth, and eventually, dividend per share growth.

What ultimately matters to long-term shareholders is, hence, dividends. Dividends is the only cash flow that a long-term shareholder receives. And this is what should drive the value of the stock price.

Final word

Don’t get me wrong. I’m not saying that investors should only invest in companies that are paying dividends. Far from it. I personally have a vested interest in many companies that currently don’t pay a dividend.

However, as a long-term shareholder, I’m cognizant of the fact that the value of the stock is dependent on the dividends that the company will pay eventually. Companies that don’t pay a dividend now or even in the near future can still be valuable if they ultimately start paying dividends.

And while cash flows and profits may not always result in dividends, it is the backbone of where dividends come from. As such, it is still important to keep in mind the future cash-generative profile of a company that will ultimately lead to dividend payments.

*Free cash flow is usually calculated as operating cash flow minus any capital expenses such as the purchase of property, plant and equipment or capitalised software costs

When Shouldn’t You Pay a Premium For a Growing Company?

Return on retained capital and the reinvestment opportunity are two factors that impact valuation and returns for an investor.

You may assume that a faster-growing business always deserves a premium valuation but that’s not always the case. Growth is not the only criterion that determines valuation. The cost of growth matters just as much.

In this article, I will explore four things:

(I) Why growth is not the only factor that determines value
(II) Why companies with high returns on retained capital deserve a higher valuation
(III) How much we should pay for a business by looking at its reinvestment opportunities and returns on retained capital
(IV) Two real-life companies that have generated tremendous returns for shareholders based on high returns on retained capital

Growth is not the only factor

To explain why returns on retained capital matter, let’s examine a simple example.

Companies A and B both earn $1 per share in the upcoming year. Company A doesn’t reinvest its earnings. Instead, it gives its profits back to shareholders in the form of dividends. Company B, on the other hand, is able to reinvest all of its profits back into its business for an 8% return each year. The table below illustrates the earnings per share of the two companies over the next 5 years:

Company B is clearly growing its earnings per share much quicker than Company A. But that does not mean we should pay a premium valuation. We need to remember that Company B does not pay a dividend, whereas Company A pays $1 per share in dividends each year. Shareholders can reinvest that dividend to generate additional returns.

Let’s assume that an investor can make 10% a year from reinvesting the dividend collected from Company A. Here is how much the investor “earns” from being a shareholder of Company A compared to Company B after reinvesting the dividends earned each year:

The table just above shows that investors can earn more from investing in Company A and reinvesting the dividends than from investing in Company B. Company B’s return on retained capital is lower than the return we can get from reinvesting our dividends. In this case, we should pay less for Company B than Company A.

Retaining earnings to grow a company can be a powerful tool. But using that retained earnings effectively is what drives real value to the shareholder.

High-return companies

Conversely, investors should pay a premium for a company that generates a higher return on retained capital. Let’s look at another example.

Companies C and D both will generate $1 per share in earnings this year. Company C reinvests all of its earnings to generate a 10% return on retained capital. Company D, on the other hand, is able to generate a 20% return on retained capital. However, Company D only reinvests 50% of its profits and returns the rest to shareholders as dividends. The table below shows the earnings per share of both companies in the next 5 years:

As you may have figured, both companies are growing at exactly the same rate. This is because while Company D is generating double the returns on retained capital, it only reinvests 50% of its profit. The other 50% is returned to shareholders as dividends.

But don’t forget that investors can reinvest Company D’s dividends for more returns. The table below shows what shareholders can “earn” if they are able to generate 10% returns on reinvested dividends:

So while Companies C and D are growing at exactly the same rates, investors should be willing to pay a premium for Company D because it is generating higher returns on retained capital.

How much of a premium should we pay?

What the above examples show is that growth is not the only thing that matters. The cost of that growth matters more. Investors should be willing to pay a premium for a company that is able to generate high returns on retained capital.

But how much of a premium should an investor be willing to pay? We can calculate that premium using a discounted cash flow (DCF) model.

Let’s use Companies A, B, C, and D as examples again. But this time, let’s also add Company E into the mix. Company E reinvests 100% of its earnings at a 20% return on retained capital. The table below shows the earnings per share to each company’s shareholders, with dividends reinvested:

Let’s assume that the reinvestment opportunity for each company lasts for 10 years before it is exhausted. All the companies above then start returning 100% of their earnings back to shareholders each year. From then on, earnings remain flat. As the dividend reinvestment opportunity above is 10%, we should use a 10% discount rate to calculate how much an investor should pay for each company. The table below shows the price per share and price-to-earnings (P/E) multiples that one can pay:

We can see that companies with higher returns on retained capital invested deserve a higher P/E multiple. In addition, if a company has the potential to redeploy more of its earnings at high rates of return, it deserves an even higher valuation. This is why Company E deserves a higher multiple than Company D even though both deploy their retained capital at similar rates of return.

If a company is generating relatively low returns on capital, it is better for the company to return cash to shareholders in the form of dividends as shareholders can generate more returns from redeploying that cash elsewhere. This is why Company B deserves the lowest valuation. In this case, poor capital allocation decisions by the management team are destroying shareholder returns even though the company is growing. This is because the return on retained capital is below the “hurdle rate” of 10%.

Real-life example #1

Let’s look at two real-life examples. Both companies are exceptional businesses that have generated exceptional returns for shareholders.

The first company is Constellation Software Inc (TSE: CSU), a holding company that acquires vertical market software (VMS) businesses to grow. Constellation has a remarkable track record of acquiring VMS businesses at very low valuations, thus enabling it to generate double-digit returns on incremental capital invested.

From 2011 to 2021, Constellation generated a total of US$5.8 billion in free cash flow. It was able to redeploy US$4.1 billion of that free cash flow to acquire new businesses and it paid out US$1.3 billion in dividends. Over that time, the annual free cash flow of the company grew steadily and materially from US$146 million in 2011 to US$1.2 billion in 2021.

In other words, Constellation retained around 78% of its free cash flow and returned 22% of it to shareholders. The 78% of free cash flow retained was able to drive a 23% annualised growth in free cash flow. The return on retained capital was a whopping 30% per year (23/78). It is, hence, not surprising to see that Constellation’s stock price is up by around 33 times since 2011.

Today, Constellation sports a market cap of around US$37 billion and generated around US$1.3 billion in free cash flow on a trailing basis after accounting for one-off working capital headwinds. This translates to around 38 times its trailing free cash flow. Is that expensive?

Let’s assume that Constellation can continue to reinvest/retain the same amount of free cash flow at similar rates of return for the next 10 years before reinvestment opportunities dry out. In this scenario, we can pay around 34 times its free cash flow to generate a 10% annualised return. Given these assumptions, Constellation may be slightly expensive for an investor who wishes to earn an annual return of at least 10%.

Real-life example #2

Simulations Plus (NASDAQ: SLP) is a company that provides modelling and simulation software for drug discovery and development. From FY2011 to FY2022 (its financial year ends in August), Simulations Plus generated a total of US$100 million in free cash flow. It paid out US$47 million in dividends during that time, retaining 53% of its free cash flow.

In that time period, Simulations Plus’s free cash flow per share also grew from US$0.15 in FY2011 to US$0.82 in FY2022. This translates to 14% annualised growth while retaining/reinvesting just 53% of its free cash flow. The company’s return on retained capital was thus 26%.

Simulations Plus’s stock price has skyrocketed from US$3 at the end of 2011 to US$42 today. At the current price, the company trades at around 47 times trailing free cash flow per share. Is this expensive?

Since Simulations Plus is still a small company in a fragmented but growing industry, its reinvestment opportunity can potentially last 20 years. Let’s assume that it maintains a return on retained capital of 26% and we can reinvest our dividends at a 10% rate of return. After 20 years, the company’s reinvestment opportunity dries up. In this scenario, we should be willing to pay around 44 times its annual free cash flow for the business. Again, today’s share price may be slightly expensive if we want to achieve a 10% rate of return.

The bottom line

Investors often assume that we should pay up for a faster-growing business. However, the cost of growth matters. When looking at a business, we need to analyse the company’s growth profile and its cost of growth.

The reinvestment opportunity matters too. If a company has a high return on retained capital but only retains a small per cent of annual profits to reinvest, then growth will be slow.

Thirdly, the duration of the reinvestment opportunity needs to be taken into account too. A company that can redeploy 100% of its earnings at high rates of returns for 20 years deserves a higher multiple than one that can only redeploy that earnings over 10 years.

Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life. I do not have a vested interest in any stocks mentioned. Holdings are subject to change at any time.

Why Capital Hoarding Is Bad For Shareholders

Companies that hoard capital are not maximising shareholder value!

Constellation Software is a company with an incredible long-term track record. Its founder and CEO, Mark Leonard, writes in his shareholder letters that a company should not hoard capital unnecessarily.

I completely agree. Money that a company cannot effectively invest should be returned to shareholders as soon as possible.

Capital hoarding dilutes returns

Here is an illustration of why capital hoarding dilutes returns.

Let’s say there are two companies: Company A and Company B. They will each generate $1 in free cash flow per share per year for 10 years before they cease operating. The difference is that Company A returns all its annual free cash flow to shareholders each year while Company B hoards its cash. Company B also earns negligible interest, and only returns all of the cash to shareholders in one go at the end of 10 years.

With the above as a backdrop, Company A’s shareholders will receive $1 each year as dividends. On the other hand, Company B’s shareholders will receive $10 as a dividend once, in the 10th year. While the total amount that is eventually returned to both sets of shareholders is $10, shareholders of Company A will be much wealthier after 10 years.

This is because shareholders of Company A can invest the dividends earned each year. A shareholder of Company A who is able to invest the dividends at 10% per year, will end up with $15.90 per share after 10 years if all the dividends are invested.

How this impacts the valuation

In the scenario above, investors should be willing to pay more for Company A’s shares.

We can calculate the values of the shares of Company A and Company B using a discounted cash flow model to get the present value of the stream of cash flows that will be returned to shareholders.

Using a 10% discount rate, Company A’s shares have a present value of $6.76 per share. Company B’s shares on the other hand, have a value of just $4.24. This makes sense as Company A’s shareholders will end year 10 with $15.90 per share, while Company B shareholders will end year 10 with just $10 per share.

As you can see, two identical companies that generate the exact same cash flow can have significant differences in their value simply due to whether the company is maximising shareholder returns by returning cash to shareholders appropriately.

Real-life impact

Unfortunately, in the real world, I notice many companies that hoard cash unnecessarily. This is especially rampant in the Singapore stock market, where many companies are controlled by wealthy families who may not have minority shareholder interests at heart. These companies hoard cash and pay only a minimal amount of dividends each year, which ends up not maximising shareholder value.

But that’s not the most destructive thing. Spending the cash on investments that destroy shareholder value is even more damaging to shareholders. Some examples of poor capital spending include buying back overpriced shares, making poor acquisitions, buying lousy assets, or diversifying into poor businesses.

Bottom line

Proper capital management can have a massive impact on the value of a company’s shares. When building valuation frameworks, investors often assume that the cash generated each year will be returned to shareholders in that same year. But that’s not usually the case. Some companies may keep the capital and invest it well, thereby creating more value for shareholders. But some may hoard the cash or make poor investments.

We have to keep this in mind when thinking about how much we should pay for a company’s shares.

Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life. I do not have a vested interest in any companies mentioned. Holdings are subject to change at any time.