Evaluate a Company's Excess Earnings and Calculate the Dividend

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Evaluate a Company's Excess Earnings and Calculate the Dividend

After paying dividends and funding core growth, a company may have cash left over. It could opt to pay down debt, which would reduce interest expense and thus increase earnings. It might make an acquisition or some other investment, though the returns here could be spotty. Finally, it might opt to buy back stock.

Whatever the company decides to do with these excess funds, we put the result into the growth bucket of our prospective total return. In other words, we assume that any cash not used for a dividend is employed to create earnings and dividend growth. To get a proxy for the added growth potential of remaining earnings, we’ll make an additional assumption that the path of least resistance is a share buyback.

Where we err

This assumption is meant to err on the side of conservatism. The earnings yield (the inverse of P/E) on most stocks is generally much less than a company’s return on equity, so we’re not projecting much bang for this last slice of our buck. And acquisitions—returns of cash to someone else’s shareholders—tend not to be priced for returns equal to existing investments.

What buybacks do for a company

Share buybacks boost earnings growth—EPS grows not only when the numerator (profit) expands, but also when the denominator (shares outstanding) shrinks. Dividing the excess earnings into the stock price gives us an "excess earnings yield," the third component of our total return calculation. So if Modern Widgets, Inc. uses the last $0.56 of per-share earnings to repurchase stock, it will be able to retire 1.2% of its shares in the first year ($0.56 divided by a $45 share price). That, in turn, gives next year’s earnings per share a 1.2% tailwind—even if earnings are flat, fewer shares outstanding mean higher earnings per share.

So what’s the dividend worth?

Totaling our hypothetical Modern Widgets, Inc.’s yield (2.4%), profit growth (5.2%), and excess earnings yield (1.2%) produces an expected total return of 8.8%. It’s important to note that this total return projection is contingent on the current stock price—we can expect an 8.8% annual return from Modern Widgets only if we acquire the shares at $45. If we pay less, our total return will be higher, and vice versa.

Consider different stock price scenarios

For example, let’s say the market hits the proverbial banana peel, and Modern Widgets is offered at $35. Meanwhile our expectations (current earnings, dividend rate, future growth) haven’t changed. Our core growth projection (5.2%) remains, but our two other factors are contingent on the stock price: At $35 the stock will yield 3.1% and our excess earnings quotient will rise to 1.6%. Our expected total return is now 9.9%, more than a full point higher. Conversely, if we wind up paying $55, our total return prospects are substantially reduced. Modern Widgets’s yield will fall to 2%, the excess earnings quotient to 1.1%, and our expected return to 8.3%.

This analysis essentially calculates fair value in reverse—instead of using a required rate of return to yield a fair price for the stock, we use the stock price to calculate the shares’ total return. Modern Widgets’s fair value is the price at which its total return is equal to the return we would require for any stock of similar risk characteristics. A leading fair value estimate for Modern Widgets was $54, which was calculated using an 8.5% cost of equity—a return virtually identical to our total return projection if we use $54 as the stock’s price.

The "right" return

What’s the "right" required rate of return? Unfortunately there’s more art than science to this, but we have two observations. First, over a very long period of time (200 years), the market has managed to return something around 10%. Lower-risk stocks would offer less, while higher-risk situations should require more. But most established, dividend-paying companies would fall in a range between 8% and 12%. Whatever you determine a "fair" return to be, demand more. This way you have a margin of safety between your assumptions and subsequent realities.