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The magic that happens when companies invest in their business

The magic that happens when companies invest in their business

I love receiving dividends. Who doesn’t? But companies that pay out a high percentage of their profits are actually harming the long-term returns of their investors. Because, when it comes to making a company more valuable, paying out high dividends is no match for ploughing profits back into the business.

To illustrate this, consider a bank account with $10 million deposited, earning a very attractive annual interest rate of 20 per cent forever. We start by assuming the account must distribute all the interest earned – $2 million – every year. If we were to auction off this bank account, we would quickly discover that, with interest rates where they are today, its market value is much higher than the equity deposited in the account. In other words, the price it would sell for at an auction (remember the sharemarket is a just a giant auction room) would be much higher than $10 million.

An initial step is to determine the return you would like on your money. Importantly, this ‘required’ return must consider the risks being adopted as well as the returns available elsewhere.  For an investor with a required return of 10 per cent, they could pay $20 million for this bank account, which is earning $2 million per annum, thereby receiving a return equivalent to 10 per cent, equivalent to their required return. If someone was happy with a five per cent return, they could pay $40 million for an account with $10 million of equity. But would they have paid too much?

Let’s fast-forward 10 years. What would this bank account trade for if it were auctioned again? The answer, of course, is that it could be higher or lower than the amount we would have received by auctioning it today.

We know, for example, that the bank account has been paying out $2 million per annum. We also know that inflation has eroded the purchasing power of that income and so the $2 million today is not what it was 10 years ago. That means, all things being equal, I am not going to obtain $40 million unless I speculate that people might be willing to pay a lot more.

We also know the account has been paying all the interest out every year, so the equity, even in a decade’s time, remains stuck at $10 million (assuming no deposits or withdrawals are made).

(As an aside, at this point you might see that this bank account, paying all of its interest out each year, is a lot like a company that pays all of its profits out as a dividend every year).

At the auction, if someone turns up willing to accept a 10 per cent return they might be willing to pay $20 million, or if interest rates are lower they may be willing to accept a 7.5 per cent return and pay $26.7 million. We can make an educated guess, but we don’t know what interest rates are going to be in the future.

If rates jump to 15 per cent, a bank account earning 20 per cent is attractive but not a lot more than bank accounts going around elsewhere. We are not going to get our $40 million returned to us in the scenario.

So, whether we get our money back will depend on interest rates, inflation and where sentiment is at the time. These are not things we can predict.

An alternative approach

Now consider a second bank account being auctioned today at the same event as the first. The second account also has $10 million deposited and earns 20 per cent interest every year, but in this second example, all of the interest is retained and invested to compound at 20 per cent per annum.

This second bank account is like a company that reinvests all of its profits back into itself, ensuring its equity grows at the same rate as the return it is generating on its equity.

At auction today, the account will trade for much more than the equity deposited and for more than the first account. What we are interested in, however, is how confident we can be about what it might trade for in a decade’s time.

By then, this second account will have earned 20 per cent of its balance each year and retained that amount. After a decade of compounding, the account will have almost $62 million deposited and still be earning 20 per cent.

At auction in a decade’s time, it is reasonable to assert that not only will it sell for more than $62 million, but it will also trade for more than the price received at auction 10 years ago. The only caveat is that an irrationally exuberant price wasn’t paid previously.

If we had paid $40 million for this bank account 10 years ago, we can be reasonably confident we earned an attractive positive return. More importantly, if sentiment isn’t negative towards the business in a decade’s time, and the economics of the business have not changed, we can be confident in the ongoing increasing value of the business.

The owner of this bank account doesn’t need to worry about China, Donald Trump or even COVID-19. If any of those factors cause the share price to fall, it is clear the only thing to be done is to buy more.

We can therefore ignore the vicissitudes of the market and continue to own the business. Inevitably the auction room will be filled with people clamouring for our brilliant bank account.

Importantly, you can now see that real investing – the kind that produces solid returns for investors – has little to do with predicting share prices and everything to do with identifying the right ‘bank accounts’.

The right bank account is the same as the right business, and the right business has essential three criteria.  Which brings me to my next blog, in which I set out the three essential criteria to identify before investing in a business.

You can read Part 1 of this three part blog here: HOW TO THINK LIKE AN INVESTOR – AND NOT A GAMBLER

You can read Part 3 here: THE THREE ESSENTIAL CRITERIA TO LOOK FOR IN A BUSINESS

INVEST WITH MONTGOMERY

Roger Montgomery is the Founder and Chairman of Montgomery Investment Management. Roger has over three decades of experience in funds management and related activities, including equities analysis, equity and derivatives strategy, trading and stockbroking. Prior to establishing Montgomery, Roger held positions at Ord Minnett Jardine Fleming, BT (Australia) Limited and Merrill Lynch.

This post was contributed by a representative of Montgomery Investment Management Pty Limited (AFSL No. 354564). The principal purpose of this post is to provide factual information and not provide financial product advice. Additionally, the information provided is not intended to provide any recommendation or opinion about any financial product. Any commentary and statements of opinion however may contain general advice only that is prepared without taking into account your personal objectives, financial circumstances or needs. Because of this, before acting on any of the information provided, you should always consider its appropriateness in light of your personal objectives, financial circumstances and needs and should consider seeking independent advice from a financial advisor if necessary before making any decisions. This post specifically excludes personal advice.

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4 Comments

  1. Alexandros Dermatis
    :

    What is a reasonable payout ratio for a high return on equity business? that won’t destroy value overtime

    • The best payout ratio for a high ROE business is zero. Anything less, produces a worse outcome for a company with a sustainably high ROE, and for its shareholders. In Australia, dividend imputation means franking credits have value for shareholders but no value for companies so there is a strong imperative to pay dividends. The consequence is that tax drives capital allocation instead of hard economic rationalism.

      We have always held the view that when a business is able to generate a high rate of return on incremental equity, it behooves management to retain profits and reinvest, rather than paying them out. And shareholders are better off financially because in the long run, the share price – at constant price/earnings ratios and assuming no capital raisings or borrowing increases – will rise by the return on equity multiplied by one minus the payout ratio. Buy shares in a company at a price/earnings ratio of 10 times and if the company generates a return on equity of 20 per cent per annum and you sell the shares years from now on a price/earnings of 10 times, your return will be 20 per cent per annum, matching the Return On Equity of the company.

      Of course a company can produce a similar result by paying all the earnings out as a dividend and issuing shares through a renounceable rights issue but if a company can generate high rates of return on equity it should be given the capital to do just that.

  2. Andrew Lonergan
    :

    Dear Roger

    I have a question that relates to your article above, specifically your emphasis on the compounding effect upon a business’ value if it reinvests its profits in itself. Why do the Montgomery listed funds aim to pay a targeted distribution yield instead of reinvesting these profits back into the funds themselves (and improving the funds value in the long term)?

    As someone new to the areas of business and investing, I fear that my question may be a very silly one. I have no doubt that there is a very good reason for this (and why it appears that other very good businesses also pay dividends instead of reinvesting their profits back into themselves). So my apologies in advance if this is a terrible question.

    I also just wanted to say a massive thank you for your (and for all of your team’s) amazing articles that do such a wonderful job of making sense of all things investing, business and economics, especially to novices like myself.

    Kind regards
    Andrew

    • Hi Andrew, Only one of the funds – the listed global fund aims to pay a distribution. The reason so many australian listed companies pay dividends is because of franking credits. Franking credits have zero value to a company but enormous value to shareholders who enjoy personal tax rates that are less than the company tax rate (pretty much every retiree). Therefore tax policy has a significant influence on dividend payout decision making. Thanks for the encouraging words

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