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.

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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.

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.

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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.

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. 

1. 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.

2. 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.
   
3. 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.

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. 

Serial acquirers are companies that acquire smaller companies to grow and they can make for excellent investments. They use the cash flow produced by each acquisition to buy even more companies, repeating the process and compounding shareholder value.

There are many serial acquirers that have been hugely successful. The best-known of them is Warren Buffett’s Berkshire Hathaway. But there are others who have been tremendous successes in their own right.

Markel Corp, for example, is like a mini Berkshire. It is an insurance company at its core, but has used its profit and insurance float to acquire numerous companies and build a large public stock portfolio. Over the last 18 years, Markel’s share price has risen by 286%, or 7.8% compounded.

In the software space, Constellation Software has made a name for itself by acquiring vertical market software (VMS) companies. Its targets are usually small but have fairly predictable and recurring streams of cash flow. Constellation Software’s stock price has compounded at 33% over the last 16 years. The total return for shareholders is even higher, as Constellation Software started paying a quarterly dividend a decade ago and has given out three bumper special dividends.

Another great example of a niche serial acquirer is Brown & Brown Inc. Founded way back in 1939, Brown & Brown is an insurance brokerage company that packages and sells insurance products. The industry is highly fragmented but Brown & Brown has grown to become a company that generates billions in revenue each year. The company has done it by acquiring smaller insurance brokerage firms across the USA to build a large presence in the country. In the last 18 years, Brown & Brown’s stock price has grown by 439%, or 9.8% per year. In addition, Brown & Brown’s shareholders have also been receiving a growing dividend each year.

After reading through the success stories, here are some things I noticed that many of these successful serial acquirers have in common.

Buying companies at good valuations

Good returns on capital can be achieved if acquisitions are made at a reasonable valuation. Constellation Software is a great example of a company that makes acquisitions at really reasonable valuations.

The companies acquired by Constellation Software are often not fast-growing. This can be seen in Constellation Software’s single-digit organic growth in revenue; the low organic growth shows that Constellation Software does not really buy fast-growing businesses. But Constellation Software has still managed to generate high returns for its shareholders as it has historically been paying very low valuations for its acquisitions, which makes the returns on investment very attractive. It helps too that the companies acquired by Constellation Software tend to have businesses that are predictable and consistent.

Focusing on a niche

Constellation Software and Brown & Brown are two serial acquiries I mentioned above that focus on acquisitions within a particular field.

Judges Scientific is another company with a similarly focused acquisition strategy – it plays in the scientific instrument space. Specifically, Judges Scientific acquires companies that manufacture and sell specialised scientific instruments. 

Since its IPO in 2004, Judges Scientific has acquired 20 companies and its share price has compounded at 27.9% per year. Its free cash flow has also grown from £0.3 million in 2005 to £14.7 million in 2021. 

Serial acquirers that focus on a special niche have a key advantage over other acquirers as they could become the buyer of choice for sellers. This means they have a higher chance of successfully negotiating for good acquisition terms.

Letting acquired companies run autonomously

Berkshire Hathaway is probably the best known serial acquirer for letting its acquired companies run independently. The trust that Buffett places in the management teams of the companies he buys creates a mutually beneficial relationship.

This reputation as a good acquirer also means Berkshire is one of the companies that sellers want to sell to. Often times sellers will approach Berkshire themselves to see if a deal is possible.

Other than Berkshire, companies such as Constellation Software and Judges Scientific also have a reputation for allowing companies to run independently. Judges Scientific’s top leaders, for instance, may only have two meetings a year with the management teams of its acquired companies and they let them run almost completely autonomously. 

Returning excess capital to shareholders

One of the common traits among all successful companies – be it a serial acquirer or not – is that their management teams emphasise shareholder value creation. This means effective use of capital.

When successful serial acquirers are unable to find suitable uses for capital, they are happy to return excess cash to shareholders. They do not let cash sit idly in the company’s bank accounts. Companies like Brown & Brown, Judges Scientific, and Constellation Software all pay dividends and rarely let excess capital build up unnecessarily on their balance sheets.

Final thoughts

Serial acquirers can be great investments. Those that are successful are usually great stalwarts of capital. While no single acquisition is the same, the thought process behind the acquisitions is repeatable. With a structured approach to acquisitions, these serial acquirers are able to repeatedly make good acquisitions to grow shareholder value. And when there are insufficient acquisition targets available, successful companies are not afraid to put their hands up and return excess capital to shareholders.

When you invest in a serial acquirer, you are not merely investing in a great business but in great managers and great processes that can keep compounding capital at extremely high rates of return for years to come.

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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 Markel Corp. Holdings are subject to change at any time.

Stocks have taken a beating this year, to say the least. The S&P 500 is down around 19% year-to-date while the NASDAQ has slumped by around 30%. Many high-growth stocks have fallen even harder than that and it is not uncommon to find stocks that are down more than 80% this year.

While these declines are painful, a downturn in stock prices does provide a potential upside: The opportunity to conduct cheap buybacks. Low stock prices mean that companies can buy back their shares at relatively cheaper levels. When done at the right prices, share buybacks can be highly value-accretive for a company’s shareholders.

Measuring the impact of share buybacks

Buybacks reduce the number of shares outstanding. A company’s future cash flows are, hence, divided between fewer shares, leading to more cash flow per share in the future. But it comes at a cost. The cash that’s used to buy back stock could have been used to pay a dividend to shareholders instead. So how do share buybacks impact the long-term shareholder?

To better appreciate what happens when a company buys back its own stock, let’s examine a simple example. Let’s assume that Company A generates $100 in free cash flow per year for 10 years before it stops operating. The company has 100 shares outstanding, so it essentially generates $1 per share in free cash flow for 10 years. Let’s imagine two different scenarios.

In Scenario 1, Company A decides to pay all its free cash flow to shareholders each year. Hence, shareholders will receive $1 per share in dividends each year for 10 years. In Scenario 2, Company A decides that it wants to buy back its shares after the first year. Let’s say its stock price is $5. Therefore, Company A can use its $100 in free cash flow in year 1 to buy back and retire 20 shares, leaving just 80 shares outstanding. From year 2 onwards, Company A decides that it will start returning its cash flow to shareholders through dividends. The table below shows the dividends received by shareholders in the two different scenarios.

In scenario 1, shareholders were paid $1 per share every year starting from the end of the first year. In scenario 2, shareholders were not paid a dividend at the end of the first year, but were paid more for each subsequent year.

We can measure the present value of the two streams of dividends using a discounted cash flow analysis. Using a 10% discount rate, the dividends in Scenarios 1 and 2 have a net present value of $6.14 and $6.54, per share, respectively. In Scenario 2, shareholders were rewarded with better value over the 10 year period even though they had to wait longer before they could receive dividends.

When buybacks destroy value

In the earlier example, Company A created value for shareholders by buying back shares at $5 a share.

But let’s now imagine a third scenario. In Scenario 3, Company A’s stock price is $7.50 and it decided to conduct a share buyback using all its cash flow generated after the first year. Company A, therefore, spent its first $100 in free cash flow to buy back 13 shares, leaving the company with 87 shares outstanding. The table below shows the dividends received in all three scenarios.

In Scenario 3, because shares were bought back at a higher price, fewer shares were retired than in Scenario 2 (13 versus 20). As such, Company A’s dividend per share in subsequent years only increased to $1.15. The net present value of Scenario 3’s dividends, using the same 10% discount rate, is only $6.04. This is actually lower than in Scenario 1 when no buybacks were done. 

This demonstrates that buybacks are only value-enhancing when done at the right price. If the required rate of return is 10%, buybacks in the example above should only be done below the net present value per share of $6.14 if no buybacks were done.

Applying this to a real-world example

We can use this framework to assess if companies are making the right decision to buy back their shares. Let’s use the video conferencing app provider Zoom as a case study. Zoom started buying back its shares this year even as its stock price tanked.

In the first three quarters of its fiscal year ending 31 January 2023 (FY2023), Zoom repurchased 11 million shares for US$991 million. This works out to an average share price of approximately US$90 per share.

The table below presents my estimate of Zoom’s future free cash flow per share. I made the following assumptions:

• Revenue grows at 10% for the first few years before growth tapers off slowly to 0% after 15 years. 
• The free cash flow margin improves from 27% currently to 45% over time. 
• Dilution from stock-based compensation is 3% a year
• Zoom stops operating after 50 years
• Its revenue starts to decline in the last seven years of its life

The table above shows the free cash flow per share generated by Zoom in each year under the assumptions I’ve made. Using a 10% discount rate and including current cash on hand (that can be used for buybacks or returned as dividends) of around US$18 per share, Zoom’s net present value per share works out to around US$112.

Recall that Zoom was buying back its shares at an average price of US$90 a piece. Under my assumptions, Zoom’s buybacks are value-accretive to shareholders.

Time to shine

Buybacks can be tricky to analyse. Although buybacks delay the distribution of dividends, they can result in value accretion to shareholders if done at the right price. With the stock prices of many companies falling significantly this year, buybacks have become a potential source of value enhancement for shareholders.

But remember that not all buybacks are good. We need to assess if management is buying back shares because the shares are cheap or if they are doing it for the wrong reasons. With stock prices down and the capital markets tight, I believe that this is a time when good capital allocation is essential. A management team that is able to allocate capital efficiently will not only cause its company to survive the downturn but potentially create tons of value for shareholders.

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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 currently have a vested interest in Zoom. Holdings are subject to change at any time.

Stock-based compensation (SBC), where a company pays its employees partly with shares, is table stakes when attracting talent for growing companies. And for good reason too.

Employees value SBC as it allows them to profit from a potential rise in a company’s stock price. From a shareholder perspective, SBC is also useful as it aligns employees’ interests with theirs. This is critical for high-level management who make executive decisions in a company; the idea is that executives who earn SBC will make decisions that drive shareholder value.

In addition, using shares instead of cash for compensation also improves a company’s cash flow. For cash-strapped businesses, SBC can be a good way to attract talent without breaking the bank.

But SBC is not without its drawbacks. This is becoming more apparent in recent times as stock prices of many fast-growing companies fall.

How does SBC work?

Before discussing some of the drawbacks of SBC, I’ll first quickly go through how SBC works. There are a few types of SBC. The most common forms of SBC that I’ve seen so far are restricted stock units (RSUs) and options.

RSUs are shares that are given to employees over a period of time. They are typically granted when an employee initially signs for a company or renews an employment contract. These RSUs vests over a few years. For example, an employee may start his employment at a company and be granted 100 RSUs that vest over four years. Essentially, the employee will get 25 shares of the company every year for four years.

The other common form of SBC is options. Options give the employee the right to buy shares of the company at a pre-determined price. Employees are also typically given options that vest over a number of years. For example, an employee may be given 100 options, with an exercise price of $100 per option, that vests over four years. This means that in each year, the employee will collect 25 options and he or she can decide whether to exercise the option and convert it into shares. The employee will need to pay the company $100 in exchange for the shares. If the share price is more than $100 in the open market, the employee can sell the shares and pocket the difference.

What’s the real cost?

Although SBC does not result in any cash expense for a company, it does have a cost – shareholder dilution.

This is because by giving away new shares to employees, the total number of the company’s outstanding shares increases. The higher number of shares outstanding means existing shareholders now own a smaller cut of the pie.

For instance, as of 30 September 2022, Palantir had around 2.08 billion shares outstanding. However, it also had around 331 million unvested or unexercised options and 131 million unvested RSUs. When vested (and if exercised), the outstanding share count will increase by 22%. Ultimately, what this means is that Palantir’s economics will have to be split among 22% more shares and each share will be entitled to lesser economics. 

When stock prices fall, employees are unhappy

SBC is designed to reward employees when stock prices rise. It also encourages employees to stay with the company in order to collect the RSUs and options that vest over time. But when stock prices fall, these RSUs are worth less and there is less incentive to stay.

For example, in March of 2021, Okta’s president of field operations, Susan St Ledger, was given 43,130 RSUs that vest over four years. At the time, Okta’s stock price was around $228; today, it’s around $67. St Ledger has around 26,956 RSUs that have yet to vest. At the time of the grant, these unvested RSUs were worth $6.1 million. Today, her remaining unvested RSUs are worth just $1.8 million.

Okta announced recently that St Ledger is retiring. Although there are many possible reasons for her retirement, the decline in value of her unvested RSUs may have played a role in her decision.

Making up for shortfalls

As shown above, falling stock prices can have a big impact on the actual dollar value of unvested RSUs. To retain existing employees, some companies may opt to increase the number of RSUs that employees receive in order to make up for the decline in the dollar value of the unvested RSUs.

Zoom is one company I know of that has done just that. In its latest annual report, Zoom said, “In October 2021, we added a feature to new and existing stock awards that provide employees with additional awards based on certain stock price criteria.” The key word here is “existing“.

In typical employee contracts, the company is not required to increase the number of RSUs if the stock price falls. This is supposed to be the risk to employees for agreeing to SBC, and employees are meant to be impacted by lower SBC, which should drive them to work harder to increase the company’s stock price. But Zoom decided to step in to make up for the loss in RSU value by increasing the number of shares paid to employees over and above what was previously agreed.

Zoom has a reputation for emphasising employee welfare and pay packages are undoubtedly part of that equation. But retroactively increasing RSU grants is at the expense of shareholders who are getting more dilution in the process.

Offering more stock to new hires

Besides increasing the number of RSUs initially agreed upon for existing employees, companies need to offer higher number of shares to attract new talent and as “stock refreshers” to retain employees.

Let’s say a potential new hire wants a pay package that includes $100,000 worth of RSUs per year. If the stock price is $100 per share, the company would need to offer the employee 1000 RSUs per year. But if the stock is only trading at $50, the company will need to offer the employee 2,000 RSUs per year. This will lead to two times more dilution.

Unfortunately for shareholders, this is exactly what is happening to many companies in the stock market today. Take Facebook’s parent company, Meta, for instance. The total value of RSUs granted in the first nine months of 2022 and 2021 were around US$20 billion and US$16 billion, respectively, at each grant date. This only a 22% increase in dollar value.

But the true cost is the number of RSUs granted. In the first 9 months of 2022, Meta granted close to 100 million RSUs, while in the same period in 2021, Meta awarded 53 million RSUs. This is an 86% increase.

The discrepancy between the increase in value versus the increase in the number of RSUs is because the weighted average grant price in the first nine months of 2022 was US$201 compared to US$305 in the first nine months of 2021. The lower stock price meant that Meta needed to promise more RSUs to provide the same dollar-value compensation to employees.

As you are familiar with by now, more RSUs granted means more dilution down the road. And it may get worse. Meta’s stock price has fallen to around US$123 as of the time of writing, which will result in even more RSUs needing to be offered to match the dollar value of compensation.

And it’s not just Meta that is facing this issue. Companies like Zscaler, Snowflake, Netflix, Okta, Docusign, Amazon, Shopify, and many more have all granted multiples more RSUs and/or options so far this year compared to a year ago.

Final thoughts

SBC is a difficult topic to fully understand. Although it’s not a cash expense, it does have a very real impact on shareholders as it ultimately results in shareholders’ split of profits being diluted down.

When stock prices are high, dilution from SBC is low and it’s not too concerning. But when stock prices are low like today, dilution from SBC can become a real problem.

This issue should not be lost on investors. We need to monitor how our companies handle this issue and whether they are doing the fiscally responsible thing for shareholders.

In my view, SBC should be reserved for executive management who make important decisions for the company and its shareholders. Other employees should be paid less in SBC and predominantly or exclusively in cash, especially when the company has sufficient cash. Employees who want stock can use cash compensation to buy stock on the open market. This reduces dilution to shareholders. This is particularly important when stock prices are low and somewhat undervalued. Companies should be trying to buy back shares at these prices rather than issuing new shares.

Although the increase in SBC is leading to more dilution, it is not totally out of control yet. For example, Meta’s dilution (the number of grants awarded against the number of outstanding shares) this year is still only in the low single-digit percentage range.

But companies need to start being more prudent with their SBC before dilution gets out of hand. I believe that businesses that are able to find the right balance in times such as these will likely be the big winners once this downturn is over.

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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. Of all the companies mentioned, I currently have a vested interest in Meta, Docusign, Amazon, Okta, Zoom, Shopify and Netflix. Holdings are subject to change at any time.

Singapore Airlines (SGX: C6L), or SIA, will be redeeming its first tranche of mandatory convertible bonds (MCBs).

These bonds were issued by the airline merely 2.5 years ago in 2020, near the peak of COVID-19 lockdowns. Back then, SIA had to pause most of its operations as passenger air travel was severely restricted due to the pandemic. Cash was short for SIA and it desperately needed to raise money. But things have improved significantly for the company this year as it reported a record profit in the first half of FY23 and free cash flow was also comfortably positive. 

With its finances moving in the right direction, SIA’s management has decided that redeeming the airline’s first tranche of MCBs would benefit its shareholders. In this article, I explore whether the airline is making the right decision.

First, is redeeming the MCBs a good use of capital?

In my view, the short answer is yes. The MCBs are a costly source of capital for SIA and redeeming them early will save the company significant money. 

The MCBs are zero-coupon bonds but have a set annual yield that starts at 4% before rising to 5%, and then 6% (head here for more detail on the MCBs). What this means is that the longer the MCBs are left unredeemed, the more expensive it becomes for SIA to redeem them in the future.

Moreover, if left unredeemed for 10 years, these MCBs will automatically convert to shares. The conversion price of the shares is S$4.84 at the end of the 10-year mark, which is lower than SIA’s current share price. (A low conversion price is bad for shareholders as it means more shares are issued leading to more heavy dilution.) Bear in mind, the conversion price is not based on the principle paid. It is based on the principle plus the accumulated yield.

If converted to shares, the MCBs will heavily dilute SIA’s current shareholders, leaving them with a smaller stake in the entire company. 

All of these lead me to conclude that redeeming the MCBs now seems like an efficient use of capital by SIA on behalf of its shareholders.

But should SIA conserve cash instead?

SIA has a history of producing irregular free cash flow.

I looked at 15 years’ worth of financial data for SIA (starting from 2007) to calculate the total free cash flow generated by the company. In that period, SIA generated a total free cash flow of a negative S$3 billion. Yes, you read that right – negative free cash flow.

In 15 years of operation, instead of generating positive cash flow that can be returned to shareholders, SIA actually expended cash.

This is mostly due to the high capital expense of maintaining its aircraft fleet. Capital expenditure for the expansion of SIA’s business was only S$5.6 billion, meaning the value of its fleet only increased by S$5.6 billion.

I say “only” because even if I exclude the expansion capital expenditure, SIA only generated S$2.6 billion in total free cash flow over 15 years. This is an average free cash flow of just S$174 million per year. Keep in mind that this free cash flow was generated off of a sizeable net PPE (plant, property, and equipment) base of around S$14 billion in 2007. The free cash flow generated is a pretty meagre return on assets.

What this shows is that SIA is a business that struggles to generate cash even if it is not actively expanding its fleet. This said, SIA does have a significant amount of cash on hand now.

With the cash raised over the past two years and the strong rebound in operations, SIA exited the September quarter this year with S$17.5 billion in cash. Redeeming its first tranche of MCBs will cost SIA around S$3.8 billion, around a fifth of its current cash balance.

The airline also has a relatively young fleet of planes now, which means its net capital expenditure requirement for maintenance is going to be relatively low in the near future, which should lead to higher free cash flows in the next few years.

And with the global recovery in air travel as countries around the world get a better handle on COVID-19, SIA’s operating cash flow is also likely to remain positive this year.

As such, I think it is fair to say that SIA does have the resources to retire the first tranche of its MCBs pretty comfortably despite its business’s poor historical ability to generate cash. 

Can it retire the 2021 tranche of MCBs?

This brings us to the next question: Can SIA retire the second tranche of its MCBs which were issued in 2021? To recap, besides the S$3.5 billion raised in 2020 via the issuance of MCBs, SIA raised a further S$6.5 billion through this second tranche of MCBs in 2021.

Including interest, the total outlay to redeem the second tranche of MCBs will be slightly more than $6.5 billion (depending on when exactly SIA redeems the MCBs). 

After redeeming the first tranche of its MCBs, SIA will be left with S$13.7 billion in cash. But the airline also has S$15.8 billion in debt (including long-term liabilities), which means it will have net debt (more debt than cash) of around $2.1 billion.

Bear in mind that the MCBs are not considered debt according to SIA’s books. Instead, they are considered equity as they have a feature where they are “mandatorily converted” in 10 years. So the debt on SIA’s balance sheet are additional borrowings which will eventually need to be repaid or refinanced. Given the small net cash position, I don’t think SIA should stretch its balance sheet to pay back the second tranche of MCBs yet.

SIA executives should also have wisened up to the fact that the company should keep some cash in its coffers to avoid another situation where they have to raise capital through the issuance of stock at heavily discounted prices (which happened during COVID-19) or through borrowing at usurious terms. A secondary offering or expensive debt in troubled times will be much more costly to shareholders than the MCBs.

The bottom line

All things considered, I think it is a good move by SIA’s management to redeem the first trance of the airline’s MCBs. The MCBs are an expensive source of capital and retiring them early will benefit SIA’s shareholders. The airline is also in a comfortable financial position to do so.

But the second tranche of MCBs is a different story altogether. After redeeming the first trance, and given SIA’s history of lumpy and meagre cash flow generation, I don’t think management will be willing to stretch its balance sheet to redeem the second tranche of MCBs just yet. 

It is worth mentioning that SIA also decided to start paying a dividend again. I would have thought that management would prefer to retire the airline’s second tranche of MCBs before dishing out excess cash to shareholders.

One needs to remember that despite its poor cash flow generation in the past 15 years, SIA still paid dividends nearly every year. In hindsight, this was a mistake by management as the distributed cash would have been better off accumulated on the airline’s balance sheet to tide it through tough times such as during the COVID pandemic. 

Ultimately, SIA paid dividends in the past 15 years, only to claw back all of the money (and more) from shareholders by issuing shares in 2020. This was certainly a case of one step forward, two steps back, for shareholders. Let’s hope for the sake of shareholders that history doesn’t repeat itself.

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 don’t have a vested interest in any company mentioned. Holdings are subject to change at any time.