The Dividend Multiple: Thinking like a Professional Investor
If you’ve spent any time studying Finance and learning about stock valuations, you’ve likely heard about the P/E ratio, known as Price to Earnings ratio. It’s a quick measurement to determine the how price the stock of a company is trading at relative to its profits. The calculation goes:
P/E = Price / EPS
EPS stands for earnings per share.
There’s generally two time-frames in which an investor will evaluate the P/E ratio: backward (usually trailing twelve months, or TTM) and forward (forecasted next twelve months, or NTM). This P/E ratio is then compared to a company’s competition and to the broader market in general to determine if the stock is trading at a high or low valuation. A higher P/E ratio, especially if it’s higher than its competitors, means a more expensive stock, and vice versa.
This financial metric came to become a staple in valuation conversations as investors generally look to earnings to determine the fair value of a stock, or what they believe they should be paying. This is subjective as some investors will have different opinions, especially when dealing with NTM earnings, but overall it works as a baseline of comparison.
How did this come to be? Valuation has always been based primarily on the earnings a company can generate. This makes sense intuitively: if you’re an investor and a company is looking to sell their shares to you, you’ll want to know how much they’re generating in profits. This will allow you to calculate an estimated timeframe that you’ll get your initial investment back and begin earning a return on your investment.
For example, say a company’s stock is trading at $100 per share. Last year’s earnings per share were $10. This would mean it takes 10 years at this rate to see a return on this investment.
While the P/E ratio can be useful, it has a distinct flaw: these ‘earnings’ do not go to the investor! They are generally retained, at least in part, by the company to reinvest into their business. It may make better sense for everyday investors to invest based on dividends, or the portion of earnings that do get paid out to shareholders.
A dividend is simply a payment to a shareholder from the profits of a company, generally paid on a quarterly basis. The company does not have a legal obligation to pay these dividends (for common shareholders) but if they have been for some time the market will continue to expect them. Management is incentivized to continue paying these dividends to support the share price.
Not all stocks pay a dividend. In fact, more companies are electing to retain their earnings and reinvest them into the business than ever before, especially high growth, tech oriented companies. This does not mean one shouldn’t invest in these companies, and their share price will generally appreciate as the company grows its earnings base, but the shareholders will not directly participate in receiving a portion of those earnings. Their return will be solely based on the price at which the stock is trading, which is more speculative and subject to price fluctuations.
Stocks that pay dividends, while also fluctuating in price, generally have a more stable investor base and cash flows to their investors to support their price. Therefore everyday investors can benefit from being a shareholder of a company without needing to sell their shares to realize a gain.
A common metric that is quoted by financial analysts is dividend yield, or simply the annual dividend divided by the price of the stock. As a quick example, if a stock is trading at $100 and pays a $2 annual dividend, the dividend yield is 2%. However, the metric we prefer to look at is the ‘Dividend Multiple’, which is the inverse of the yield. At a 2% dividend yield, it would take 50 years to get your original investment back from the dividend alone.
At EVCM, we prefer to invest in assets that generate cash flow. Just as professional investors assess an investment by its cash flows and estimated time for their initial investment to return, so too can everyday investors. But most people will, rightfully so, say 50 years is a long time to wait for your money to return. However, there are two ways that this timeframe can be shortened:
Some companies make it a priority to raise the dividend each year, which would increase the current yield to an investor relative to their initial investment.
An investor can choose to reinvest the dividend back into the stock automatically to buy more shares, also known as a DRIP (Dividend Re-Investment Program). This will increase the nominal dividend over time via the accumulation of additional shares being purchased, but an investor should only do this if they believe in the long term trajectory of the company. They will also need to be mindful of the allocation to a single stock in their portfolio, as an outsized position in one stock could put an investor’s portfolio at greater risk should the price drop drastically.
Everyday investors can benefit from viewing their investments in a similar manner that professional investors do. Cash flow and time to recoupment of the initial investment are key factors every investor should take into consideration.
At EVCM, we manage retail client portfolios in a similar manner, giving everyday investors access to institutional level money management. If you’re interested in working with us, click the ‘Contact’ page at the top.
Happy Investing!