Thanks for that! Just another random thought, hypothetically speaking, would a company that gives a 6% dividend yield and 0% earnings growth give the same shareholder return as one with 6% earnings growth and no dividend, holding all else constant?
Thanks for that! Just another random thought, hypothetically speaking, would a company that gives a 6% dividend yield and 0% earnings growth give the same shareholder return as one with 6% earnings growth and no dividend, holding all else constant?
Isn't debt repayment also a form of investor yield? If the company uses its cash to payback debt liabilities decrease and book value increases. This should directly impact the stock price returns.
Buybacks might be a more powerful signal because in most cases management thinks the stock is undervalued. But debt paydowns implies strong confidence in the company cash flows.
Thanks for the comment. It depends on what you're using for your valuation multiple. If you are looking at P/E, then we're only looking at the market cap and debt doesn't have a direct impact here (paying down debt could make the stock safer and thus it could cause investors to bid up the P/E, and also removing interest charges could cause earnings to grow, but the simple fact remains that the three things that matter are earnings growth, P/E multiple, and buybacks).
Now, we could use EBIT growth and EV/EBIT multiple, in which case debt is obviously part of that EV calculation, so if we are looking at the full enterprise value and we pay down debt and EV stays constant, then that by definition means market cap has risen.
The market must be value liabilities into the stock price. All other things being equal, a company with 0 debt won't be worth more than a company with total debt as high as 1 year earnings or more?
Sure, the market might value a company with no debt at a higher level. If so, then the P/E multiple will rise. The thing to remember is this is just the math: a stock price will move from three things: higher or lower P/E, earnings growth, and higher or lower shares outstanding. Lots of factors (including debt) will go into how the market perceives the value. But if you know only the change in those three things, you'll know exactly what the stock price change is.
Yep, if paying down debt increases earnings, then that of course shows up in earnings growth. So it’s not the book value that matters, it’s the simple equation: a stock price appreciation equals the earnings growth x p/e appreciation x change in shares. Lots of factors go into what drives those three, including debt.
I read your other posts about W. Buffet purchase of Japanese stocks and the impact of incremental ROIC on total returns.
- Shares repurchases explains a part of the stock total returns
- Debt repayments affects stock returns, both as reduced liabilities and less interest payments
- Incremental ROIC affects earnings, which affects stock returns
But you can't use market cap both as an explaining variable (in the PE numerator) and a dependent variable (stock returns). PE expansion is a consequence of the factors above among other things.
I don't see PE as an "engine". I agree of course that cheaper stocks carry less risk
May 23, 2023·edited May 24, 2023Liked by John Huber
John, great piece. Thanks for sharing it! We've been growing in our understanding of the power of low PE's over the long term. We think some of the energy names provide great examples on this potential today.
In the piece we wrote three weeks ago, we talked about how David Einhorn seemed to be shifting his focus to plays with low PE's and can produce returns by returning capital.
First of all great article - the three engines of value really makes sense!
Just a question regarding earnings growth and what you mean by that. Do you refer to the growth rate in net income as your earnings, or do you mean earnings per share growth? Since the former will not be affected, at least not positively, by share buybacks, whereas the latter would technically increase when you the share count is reduced, does it not make sense to think about net income rather than EPS?
I think another core reason many investors focus on a change in multiple is that ultimately most investors are not long-term oriented and a change in multiple is a great way to drive short-term performance. The article I linked below states that the average holding period for an investment is something like 10 months in 2022.
I'm guessing the average mutual fund holding period isn't much better and many investors judge mutual fund performance over short-term periods (e.g. one year performance relative to the S&P500). It's honestly something that has frustrated me quite a bit even outside of the retail investment space. If you look at private equity, which owns a large number of privately held middle market companies, you see a similar short-term focus on maximizing an exit that may occur within a short (e.g. five year) holding period. I've seen companies in this space taking actions that help to maximize the exit multiple, but I think will ultimately hurt the ability of the business to maximize free cash flow over the long-term or that build an interesting story or narrative, but doesn't have much substance if you look under the covers.
Then if you look at the venture capital and startup ecosystem many of the people I see building startups are far more concerned about chasing a maximal valuation versus building a long-term business. This can often chasing fads like blockchain or more recently trying to include AI and LLMs into products where it doesn't make sense.
I guess it shouldn't be surprising that the majority of people want to get rich quickly as soon as possible with minimal effort.
I use my own internal estimate of what I believe the internal rate of return of the business will produce, and then I determine what I think the proper terminal multiple will be for the business. It's essentially a DCF, and for many businesses I explicitly use DCF's as an estimate of value, but the three engines framework is a more intuitive way to think about value. DCF's work well (imo) for businesses that are throwing off a lot of cash. For businesses that are reinvesting earnings, I think the 3 engines framework is more intuitive. Basically: what is the cash I'm getting now via div/buyback, and what is the cash I'll get later (which is the return they get on reinvested capital). That's the total return we'll get, plus any change in multiple.
Awesome piece John! What about the impact of dividend yields on total shareholder returns?
Thanks Alex. Yes, I would consider dividends and buybacks as an overall "capital return engine". They are part of that buyback engine
Thanks for that! Just another random thought, hypothetically speaking, would a company that gives a 6% dividend yield and 0% earnings growth give the same shareholder return as one with 6% earnings growth and no dividend, holding all else constant?
Thanks for that! Just another random thought, hypothetically speaking, would a company that gives a 6% dividend yield and 0% earnings growth give the same shareholder return as one with 6% earnings growth and no dividend, holding all else constant?
Isn't debt repayment also a form of investor yield? If the company uses its cash to payback debt liabilities decrease and book value increases. This should directly impact the stock price returns.
Buybacks might be a more powerful signal because in most cases management thinks the stock is undervalued. But debt paydowns implies strong confidence in the company cash flows.
Thanks for the comment. It depends on what you're using for your valuation multiple. If you are looking at P/E, then we're only looking at the market cap and debt doesn't have a direct impact here (paying down debt could make the stock safer and thus it could cause investors to bid up the P/E, and also removing interest charges could cause earnings to grow, but the simple fact remains that the three things that matter are earnings growth, P/E multiple, and buybacks).
Now, we could use EBIT growth and EV/EBIT multiple, in which case debt is obviously part of that EV calculation, so if we are looking at the full enterprise value and we pay down debt and EV stays constant, then that by definition means market cap has risen.
"debt doesn't have a direct impact here"
The market must be value liabilities into the stock price. All other things being equal, a company with 0 debt won't be worth more than a company with total debt as high as 1 year earnings or more?
Sure, the market might value a company with no debt at a higher level. If so, then the P/E multiple will rise. The thing to remember is this is just the math: a stock price will move from three things: higher or lower P/E, earnings growth, and higher or lower shares outstanding. Lots of factors (including debt) will go into how the market perceives the value. But if you know only the change in those three things, you'll know exactly what the stock price change is.
Then debt paydown yield does have a direct impact on total market returns.
Buyback Yield reduces shares, thus increases EPS, thus increases the stock price
Debt Paydwon Yield reduces liabilities, thus increases book value, thus increases the stock price
Both BBY and DPY show management confidence in the company valuation (the former) and future cash flows (the latter).
Does the parallel hold?
Yep, if paying down debt increases earnings, then that of course shows up in earnings growth. So it’s not the book value that matters, it’s the simple equation: a stock price appreciation equals the earnings growth x p/e appreciation x change in shares. Lots of factors go into what drives those three, including debt.
I read your other posts about W. Buffet purchase of Japanese stocks and the impact of incremental ROIC on total returns.
- Shares repurchases explains a part of the stock total returns
- Debt repayments affects stock returns, both as reduced liabilities and less interest payments
- Incremental ROIC affects earnings, which affects stock returns
But you can't use market cap both as an explaining variable (in the PE numerator) and a dependent variable (stock returns). PE expansion is a consequence of the factors above among other things.
I don't see PE as an "engine". I agree of course that cheaper stocks carry less risk
This was a great thread 🧵
John, great piece. Thanks for sharing it! We've been growing in our understanding of the power of low PE's over the long term. We think some of the energy names provide great examples on this potential today.
In the piece we wrote three weeks ago, we talked about how David Einhorn seemed to be shifting his focus to plays with low PE's and can produce returns by returning capital.
https://specialsituationinvesting.substack.com/p/shadowing-david-einhorn#details
Link is not working for some reason
Hi!
First of all great article - the three engines of value really makes sense!
Just a question regarding earnings growth and what you mean by that. Do you refer to the growth rate in net income as your earnings, or do you mean earnings per share growth? Since the former will not be affected, at least not positively, by share buybacks, whereas the latter would technically increase when you the share count is reduced, does it not make sense to think about net income rather than EPS?
Hi Simen. Growth would be the growth of the net income. EPS would include the impact of buybacks.
I think another core reason many investors focus on a change in multiple is that ultimately most investors are not long-term oriented and a change in multiple is a great way to drive short-term performance. The article I linked below states that the average holding period for an investment is something like 10 months in 2022.
https://www.etoro.com/news-and-analysis/in-depth-analysis/the-costs-of-rising-short-termism/
I'm guessing the average mutual fund holding period isn't much better and many investors judge mutual fund performance over short-term periods (e.g. one year performance relative to the S&P500). It's honestly something that has frustrated me quite a bit even outside of the retail investment space. If you look at private equity, which owns a large number of privately held middle market companies, you see a similar short-term focus on maximizing an exit that may occur within a short (e.g. five year) holding period. I've seen companies in this space taking actions that help to maximize the exit multiple, but I think will ultimately hurt the ability of the business to maximize free cash flow over the long-term or that build an interesting story or narrative, but doesn't have much substance if you look under the covers.
Then if you look at the venture capital and startup ecosystem many of the people I see building startups are far more concerned about chasing a maximal valuation versus building a long-term business. This can often chasing fads like blockchain or more recently trying to include AI and LLMs into products where it doesn't make sense.
I guess it shouldn't be surprising that the majority of people want to get rich quickly as soon as possible with minimal effort.
Hi - very nice presentation. The link to it stopped working for some reason though. Looks like the permissions have changed
I use my own internal estimate of what I believe the internal rate of return of the business will produce, and then I determine what I think the proper terminal multiple will be for the business. It's essentially a DCF, and for many businesses I explicitly use DCF's as an estimate of value, but the three engines framework is a more intuitive way to think about value. DCF's work well (imo) for businesses that are throwing off a lot of cash. For businesses that are reinvesting earnings, I think the 3 engines framework is more intuitive. Basically: what is the cash I'm getting now via div/buyback, and what is the cash I'll get later (which is the return they get on reinvested capital). That's the total return we'll get, plus any change in multiple.