When you begin evaluating companies that you want to invest in, it’s important to understand how those companies will deliver value back to you. Typically, companies will deliver value back to you in various forms: share buybacks, reinvestment for growth opportunities, or dividends.
Dividends are an important instrument for investors because they could offer a steady stream of income at a lower tax rate, and they offer the investor insight into the intrinsic value of a company. From a company standpoint, dividends are a function of how a company utilizes its profits, or capital allocation. Some companies may return most or a partial amount of the profit to shareholders as a dividend. When they return a partial amount, they can utilize the remaining for company growth and expansion, with the goal of obtaining more profits to return to their shareholders. Either way, dividends are a crucial factor to think about when making investment decisions.
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Your Rich Aunt Bestows You With $5M
Imagine your filthy rich aunt calls you with a surprise. She really adores you and tells you that she wants to give you $5M dollars for you to invest, and that this investment is wholly for you. But there is ONE caveat to receiving this money … she informs you that you can never sell any shares of the stock.
What would you do?
The Buy and Forever Hold Strategy
This is a buy and hold forever strategy – AKA Warren Buffett’s favorite strategy.
We know there are two types of companies that would likely fit into this category: (i) a rock-solid company that delivers constant returns, and (ii) a growing company that has steady returns with its goal of delivering larger returns to its shareholders. They both offer high returns, but which one will give us the highest return on our investment? Let’s take a look at how to measure this.
Internal Rate of Return (IRR)
The first metric we’ll review, is the Internal Rate of Return or IRR. The simplest way to describe this is the percentage rate that will be earned on the money you’ve invested. There are 4 components to look at when analyzing the IRR of a company.
- Size of the Dividend – The larger the dividend that’s paid, the higher the IRR.
- Timing of the Dividend – It’s better to be paid on the earnings over a shorter period of time. If the company is paying back $50M over 5 years, it’s better than the company paying it back over 10 years.
- Cash Outflow – The cash you invest. In this case, we invest $5M worth of shares. This $5M would be our “outflow.” Cash flow out.
- Cash Inflow – The cash you receive from the investment. Our $5M investment will return cash back to us in the form of dividends – usually, but not always. Cash flow in.
Here’s how it works:
The red bar in the chart indicates an “outflow” or money spent to purchase shares. In our example, that would be the $5M invested. Each green bar represents cash “inflows” as cash is received back from dividends ($d1 at t1, $d2 at t2, etc.)
The IRR calculation tells us our IRR based on the size of our dividends, and the timing in which we would receive them.
The IRR is a fundamental way in which we should view every investment. Ultimately, we want to know what’s the purpose of investing. The fundamental purpose is to offer cash now in hopes of receiving a larger amount of cash at a later time. By no means, is this a perfect science, but it is our expectation.
To simplify IRR, we can ask the following questions: “How much cash do I put in? How much cash can we take out?” The larger the sum of cash, and the faster we can withdraw the cash, the larger the IRR.
Applying the Buy and Hold Forever Strategy
Using the buy and hold forever strategy – the only cash that we will ever take out is paid in dividends because, the terms in our aunt’s agreement of allowing us to have the investment money, state that we can never sell. Therefore, our return is only driven by 1) our initial purchase price; and 2) the dividend amounts that will be paid to us.
This is a very important point to keep in mind.
For a buy and hold forever strategy – the only thing that matters are dividends.
Revenue, Earnings, Free Cash Flow, and Market price changes are only significant to you in the sense that they can increase our dividends or advance our dividend payments.
This does seem bizarre and illogical, but remember, our aunt said we’re not allowed to sell our shares, so the market price has no bearing on our investment.
Investor v. Speculator
This is the key difference between someone who is an investor and someone who is a speculator. Investing is based on fundamentals. A speculator is purchasing with the idea that eventually someone will pay a higher price for it.
Warren Buffett is a perfect example of the buy and hold forever strategy. His investment strategy is simply based on whether the dividends paid will outpace the investment cost and produce his target IRR. Although, he is not bound to never selling, he infrequently sells, unless there’s good reason.
To understand IRR further, let’s work through a couple of straightforward examples.
A company’s shares are trading at $50.00 per share at the time we’re purchasing them. Our $5M would get us $5M / $50.00 = 100,000 shares of the company.
Price to Earnings (P/E) is the ratio for assessing a company that evaluates its current share price relative to its earning per share (EPS).
Currently, that company is trading at 10x trailing Price to Earnings (P/E) at the time we bought. This means in the year prior to us purchasing the shares, the company would have earned $5.00 for every share that exists. ($50.00 per share) / (10 P/E)
Analyzing a Rock-Solid Company
The easiest type of company to analyze is a predicable rock-solid company. This is a thriving, mature, well-established, well-run company. All the profits from this company are distributed back to the shareholders, as there’s no meaningful way to reinvest them for future growth.
Using our figures from above, if we invest our $5M into the rock-solid company, we will expect to receive $5.00 / share in dividends every year. The dividends will continue to stay the same over time.
With our $50.00 / share price, we would receive $5.00 each year equating to 10% IRR. ($5.00 / $50.00) This is a simple rock-solid business with steady dividends and no growth.
Here is a simple chart to illustrate how an investment would look into the rock-solid company. Cash going out initially followed by a steady ‘inflow’ of consistent dividends.
Analyzing a Growing Company
Now, let’s look at a growing company. These are companies that are generating massive amounts of cash each year and re-investing them back into the company. The company decides how much money to reinvest and then gives the remainder back to shareholders in the form of a dividend.
Return on Invested Incremental Capital (ROIIC) measures the alteration in earnings in one period as a percentage of change in investment in the previous period. This method is used to comprehend the impact of strategic investments on a company’s finances.
For illustrative purposes, the growing company may decide to keep and reinvest 40% of earnings and pay the other 60% out as a dividend. The growing company has an expectation that it will earn 10% on the reinvested money. We call this Return on Invested Incremental Capital (ROIIC). Using our original $50.00 per share price. We would now receive $3.00 / share as a dividend and the dividend would be expected to grow at 4% a year.
Our IRR would now be the 4% of expected dividend growth, plus the $3.00 / share (6% yield on $50.00), so our IRR would equate to 10% per year. Even though this is a growing company, it still has the same IRR as the rock-solid business – 10%.
When evaluating a company, the ROIIC helps us understand the true growth and expected IRR. The concept is simplistic to understand, the math might seem a little complicated, but once you practice it a few times, it will be straightforward.
For growing businesses, the IRR formula is simple.
The IRR will equal the business’ growth rate plus the initial dividend yield.
With our 4% growth rate and $3.00 per share in dividends (6% yield from above), the IRR will be 9% per year.
So, let’s incorporate a different ROIIC to see how it looks. Using 15% ROICC instead of 10%. Now the dividends would be growing by 6% rather than 4%. So, this would make the IRR 12% (6% + 6%). From this, we can conclude that if the company can maintain the 15% ROICC, then our dividends will continue to grow and so will the IRR – earning us more money.
There are a couple of caveats to growing companies that you should be aware of. In some cases, reinvesting the money back into the company may not achieve the desired return, resulting in a lower IRR. In this case, the company would have been better off paying the full dividend, rather than reinvesting the money.
Massive tech companies are notorious for retaining billions of dollars each year, looking for places to invest and returning no dividends to shareholders, such as Google, Amazon, Facebook, Alibaba, and Adobe. Most of these companies are building massive amounts of cash reserves that are earning near 0% ROIIC. In the meantime, they are looking to acquire a company or technology that could transform the business, but the longer it takes to do so, the more it hurts their shareholders. And the more cash that they keep reserving, and not using, the harder it will be for them to achieve higher yearly returns for their shareholders. Think time value of money – the money is not compounding, and inflation is slowly eroding the return.
Apple is great example of what to do with a moneymaker business. For years, Apple was stock piling cash and not deploying it for growth. As successor to Steve Jobs, Tim Cook encompassed his role as CEO of Apple, he took the approach of giving back profits in the form of dividends to their shareholders. This built a massive amount of confidence and attracted many of the greatest investors in the world; including Warren Buffett, who took it upon himself to make it his #1 investment in Berkshire Hathaway’s portfolio. It now comprises of around 40% of Buffett’s investment portfolio. He does this because he knows this is the largest source of income business on the planet, and it’s paying massive dividends and has strong fundamentals making it a more stable and secure investment.
Great management teams are always weighing the options of what to do with their excess capital. They must look at paying dividends against reinvesting into acquisitions, company expansion, and share buybacks, rather than losing out on these opportunities and simply letting the cash pile up.
Dividend Tax Advantage of the Wealthy
The last thing to note is taxes. If a company is paying shareholders in dividends, the shareholder now has a tax burden. However, taxes on qualified dividends are typically subject to lower rates than regular income and are 0% for people in lower income tax brackets. This is a huge benefit for investors, and the greatest investors have this on the forefront of their mind.
This is one of the great tax advantages that the wealthy typically utilize for their income. Most wealthy people never want to sell their shares in a company. Instead, they generate large amounts of income simply holding shares for life – using the dividends as income. If they need additional money, they can always use their shares as collateral to obtain financing (loan, line of credit). This way, they are never exposed to excessive capital gains and continue to hold income generating assets at a lower tax rate.
Let’s hope your ‘aunt’ will give you a nice surprise one day, and if she does, you’ll know exactly how to approach this!
Conclusion
When it comes to taking a fundamental approach to investing, the number one thing you need to understand is how much money an investment will return to you over what period of time, or the internal rate of return (IRR).
We know that companies can reward their long-term shareholders in a variety of ways. We discussed using a steady dividend program, and growth plan associated with dividends. And there are other ways such as share buybacks. Mature large companies will typically use a combination of methods to reward its shareholders. For Warren Buffett’s buy and hold forever strategy, purchasing stock at a fair price with the desired IRR is the best way to generate long-term steady returns. And if you look closely at his investments; nearly every one of them pays dividends.
Remember:
Purchasing stock at a fair price with the desired IRR is the best way to generate long-term steady returns.