As with all investing the devil is in the detail.
ASX listed companies tend to have far higher dividend payout ratios than their overseas counterparts and, because of this high pay out ratio, it is critical to look at ROE on a reinvested basis and to be realistic about what is achievable in the future.
A company that has a payout ratio of 45% and a ROE of 30% is, in fact, only compounding the 55% of earnings reinvested (55% x 30% = 16.5%).
Over a 10 year period the Retained ROE compounds to 118% of the original investment but the dividend element compounds at a lower rate to 53% of the original investment..
So, investing $10k at an ROE of 30% for 10 years you would end up with a capital value of $46,053 plus total dividends of $29,498.
If the company paid no dividends the capital at the end of the period would be $137,856. Realistically the only way companies can keep compounding ROE at very high rates is by paying out dividends - taken to extremes 30% ROE on $10k fully compounded over 40 years comes to $361.2 million. So a 10 million company today would be a 361.2 billion company in 40 year time!
The table below illustrates the numbers
Hi @Strawman, I like your reasoning!
When we talk about valuation in this example we are trying to arrive at a price we would be prepared to pay for the $10k of starting equity knowing that it will deliver a 30% ROE into perpetuity. In other words we are trying to arrive at a Price to Book (PB) multiple for these businesses.
We don’t have any historical PB or PE ratios to work on and no analysts telling us what the PE ratio should be etc. We are left to our own devices and…Maths!
So how do we go about finding a reasonable multiple from first principles and maths?
To be honest, I cheated to get my valuations of $68.80 for business #1, and $90 for business #2.
I simply plugged the values into McNiven’s StockVal Formula using a required return of 10% and Shareholder Equity of $10K for each business and then plugging in the reinvestment and dividend details for each (including franking credits).
However, I have always been curious about how McNivens “Black Box” formula works and I was hoping someone would solve it for me (Lazy type)!
As you said Strawman, Business #2 is easier, so that’s where I’ll start. I will attempt to work out what McNiven’s formula is telling me from first principles.
It looks to me like my trusty online compound interest formula might be useful here.
First, let’s see if it arrives at the same terminal capital value as @endean’s spreadsheet.
That’s a relief, it’s spot on!
OK, now comes the real test. According to McNiven I can pay $90K for Business #2 and still get a return of 10% per year.
That might be true Mr. McNiven, but how many years do I need to hold this business to get my 10% return??
Now I’m gong to make this look easy, but I’ve been playing around with the online calculator for a while to come up with the following answers.
OK, I’ve trusted in McNiven and paid $90K for only $10K of equity in Business #2 and I’m going to hold in there and let compounding do it’s work for 13.5 years.
So to achieve my 10% return on my investment of $90k over 13.5 years I must end up with at least $326K in capital at the end.
Here goes…
Voila! One I prepared before the show with a total capital return of $345K and my required return of 10% per year has been achieved!
Now what if I needed to cash up before 13.5 years to go on an overseas holiday? (a very expensive one!)
Surely there would be someone else out there who would be willing to pay me 9 times the current Book Value (like I did) to take over Business #2?
Does that also mean that after 13.5 years there would be someone out there who might pay me 9 x $335K, or $3015 for Business #2? Compounding is just mind boggling!
As for Business #1 and reinvestment and dividends and franking, for now I’m just going to trust McNiven is right! :)
Separating wheat from the chaff?
What do you use as your first filter when adding a new business to your portfolio?
For me it’s simple…Return on Equity (ROE). From my time on Strawman I realise the first filter is very different for each investor. For some it might be ‘a long runway for growth’ and for others ‘the next big thing’. For some it might be very low risk business with a good fully franked dividend?
For the largest part of my investment decisions ROE is the first cut, and the higher the ROE the better! So I start by looking for businesses where analysts are forecasting ROE to be more than 20% in the foreseeable future. However, not all my investments IRL have forecast ROE greater than 20%!
There are plenty of businesses on the ASX that have ROE greater than 20%, so it shouldn’t be that hard for me to load up my portfolio…Right?
Well, it seems everybody wants a business with a very high ROE and generally none are cheap. So the question is, what is a fair price to pay for a business based on its future ROE?
I heard recently that Buffet said something like: if you hold onto a business for long enough YOUR returns get closer to the ROE of that business. I haven’t proved this but It does makes sense to me.
Let’s do a few examples for businesses that reinvest all their earnings at different ROEs using an online compound interest calculator.
To make it really simple we will invest $1 for 10 years at five different ROEs ( 5%, 10% , 20%, 40%, 80%) allowing the net profits to compound annually at the same ROE.
Here are our total returns after investing $1 for 10 years:
At 5% interest = $1.63
At 10% interest = $2.59
At 20% interest = $6.19
At 40% interest = $28.93 and
At 80% interest = $357.05
Example of $1 invested at ROE of 5% for 10 years https://www.calculatorsoup.com/calculators/financial/compound-interest-calculator.php
Now I haven’t found too many banks that will pay me 5% interest on my investment, let alone 80%. But I do know there was at least one business on the ASX with a ROE of over 90% in FY22 (Lovisa, ASX:LOV). What’s more, analysts are forecasting earnings that will put Lovisa’s ROE over 100% going forward?
Now, if investing were only that simple I could put all my money in Lovisa and let it compound forever!
OK, let’s look at Lovisa with its big ROE of > 90%. This represents over 90% return on YOUR EQUITY in the business (Book Value). Yesterday you could have bought one Lovisa share for $22.73. How much equity do you get in Lovisa for your $22.73 per share? Just $0.60, yes that’s right, 60 cents per share! So there’s the catch!
There is so much completion in the market to own a high quality, well-run business that investors are willing to pay 38 TIMES the EQUITY they will own in Lovisa. The million dollar question…Is Lovisa worth 38 times Equity. What multiple of the Book Value in Lovisa can you afford to pay and still get a very good return? What is a really good return on your investment? What are the risks if Lovisa’s ROE drops to 70%? So many questions. Too many questions to explore before breakfast…and I need to oil our deck this morning! But, I WILL BE BACK in the near future to explore some of these questions.
Cheers,
Rick
Disc: I sold all my Lovisa shares recently…but perhaps I should have held?
I’ve just put together a spreadsheet for the McNiven StockVal formula. @PortfolioPlus asked if I had one. I do now (screenshot below).
If you would like to try it, please DM me with your email and I will share a time limited OneDrive link so you can download and try it. The grey columns contain formula so don’t change these. Some of the grey columns are hidden. You can play around with all the other columns including the Required Annual Return so that the current valuation matches the current price. I usually start with a Required Annual Return of 10% which is generally my minimum buy requirement.
cheers
Rick
