How Do Retained Earnings Fuel Growth?

Transcription

1 How Do Retained Earnings Fuel Growth? Newsletter of Value Investing n 10 Winky Hau 1

2 Dear all, I m happy that I ve got one positive feedback about the presentation in the last issue! I will keep this way in future. And, two of you start to help me to collect some important data. Many thanks! It s very encouraging to me! As I know, at least one of you hold some stocks of China Life (2628.HK). I don t research on this stock but I m quite surprised that their dividend payout ratio is very low. Let s have some figures in the recent two years earning record of China Life. 2

3 Earnings, dividends and payout ratio of China Life ( 中國人壽 ) earnings 2006: : : 27 dividends 2006: : : 0 payout ratio: 2006: 18.7% 2005: 14.3% 2004: 0% Their growth of earning is very impressive, for insurance market in China has big room to develop It is also very surprising to me that the payout ratio is very low How about price-to-earning (P/E) ratio? Let s see its historical price chart Dividends = Earnings Retained Earnings Dividend Payout ratio = Dividends / Earnings 3

4 2005 earnings: 35 dividends: 5 P/E = earnings: 75 dividend 14 P/E = earnings: 7 dividends: 0 P/E = earnings: 27 dividends: 0 P/E = 20 Its IPO was priced at 4.55 It seems the prevailing P/E is around 35 4

5 How do retained earnings fuel growth? I m not going to research on China Life Just to have some impression on the outlook of its earnings, dividends and price The outstanding point is that China Life retained a big portion of its earnings (from 81% in 2006 to 100% in 2003 and 2004) How much future earnings is expected to grow fueled by such big retained earnings? Surely this is not an easy question Yet, let s examine a very simple and ideal model It may help to get some initial ideas 5

6 350 Earnings % growth 10% growth 0% growth Company A Company B Company C Year These three companies run the same business and their recent earnings figures are shown. Just based on this figure, which company do you choose to invest in? 6

7 Choice from common mindset Fast growth, great market potential, room for expansion These are good reasons to pick a stock in common mindset Therefore, we tend to choose high growth rate company A, right? Well, at least, it will be quite stupid to choose zero growth company C Company A, B and C represent the same business but with different dividend payout ratio 0%, 50% and 100% respectively 7

8 100% Payout Ratio Model Assets X Sales 200 There are surely many underlying assumptions: 1) No depreciation 2) No liability 3) No capital expenditures 4) 5) Earnings 20 (10% sales) Dividends 20 (100% payout) Assets = Shareholders Equity + Liabilities If liability = 0, Assets = Equity 8

9 100% Payout Ratio Model Next year Assets X Sales 200 Earnings 20 (10% sales) Since there is no retained earnings to fuel its growth We expect there is no growth in sales and thus earnings! Dividends 20 (100% payout) 9

10 50% Payout Ratio Model Assets X Sales 200 Earnings 20 (10% sales) Retained 10 Dividends 10 (50% payout) In this case, 50% of earnings is retained to expand its assets. 10

11 50% Payout Ratio Model Next year Assets X Sales 220 Earnings 22 (10% sales) Retained 11 Dividends 11 (50% payout) The expanded assets produce more sales. Sales grows and so do earnings! 11

12 50% Payout Ratio Model Next next year Assets X Sales 242 Earnings 24.2 (10% sales) Retained 12.1 If all ratios keep constant, both assets and earnings should grow at a rate of 10% forever! Dividends 12.1 (50% payout) 12

13 0% Payout Ratio Model Assets X Sales 200 Earnings 20 (10% sales) Retained 20 Now all earnings are retained to fuel its growth! 13

14 0% Payout Ratio Model Next year Assets X Sales 240 Earnings 24 (10% sales) Retained 24 Again, the expanded assets produce more sales. Sales grows and so do earnings! 14

15 0% Payout Ratio Model Next next year 2 X Assets 144 Sales 288 Earnings 28.8 (10% sales) Retained 28.8 Its earnings grow at a rate of 20% forever! Apparently, it is very impressive, isn t it? 15

16 Summary of earnings and dividends End of year Total Payout ratio Earn. Retain. Div. Earn. Retain. Div. Earn. Retain. Div. Earn. Retain. Div. 0% % % Remember John Williams holds that retained earnings should be eventually paid out as dividends in its lifetime; if not, it should be the money lost. Therefore, we expect that 72.8 from the 0% model be paid to the shareholders some days in future! 16

17 What do we learn? Compared to the 60 dividends paid already by the 100% model, the 72.8 earnings of the 0% model is not that impressive! Moreover, that realized 60 dividends can actually be reinvested in other stocks! Most importantly, it is uncertain that if that 72.8 retained could be paid out eventually! 17

18 What do we learn? In these simple models, we can conclude the following: If a company expands its equity at a certain rate (e.g. 20%) and retains all of its earnings (i.e. 0% payout ratio), its earnings should, at least, grow at the same rate (i.e. 20%) in order to justify its 0% payout policy. Therefore, the 20% earnings growth of company A is actually not that attractive! 18

19 Let s examine China Life again Earnings 19

20 Let s examine China Life again Year Sales (million) 78,883 76,806 98, ,311 Sales growth n/a (2.6%) 27.9% 50% Earnings Earnings growth (4252) unknown 7, % 9, % 19, % still 5 times? Payout ratio 0% 0% 14.3% 18.7% Accumulated retained earnings unknown 1,620 16,388 34,032 Equity 62,436 66,530 80, ,665 Equity growth n/a 6.56% 20.8% 73.8% Part of the increase in equity comes from issue of shares Is it justify to have such low payout policy? The accumulated retained earnings is 1.7 times of the earnings in 2006 When will all retained earnings be paid in future? 20

21 What s reasonable dividend payout ratio? In the next issue, I m going to introduce a valuation formula. And we will learn how important dividend is in the valuation. It s even more important than earnings! Best Regards, Winky Freiburg 15 September,