On Realizing Gains, Compounding Value, and Equity Perpetuity

This is Part 2 of a Series. Go to Part 1: On Price, Value, Value Investors, and Equity Perpetuity

The following are excerpts from a discourse I had with a fellow investor with regards to realizing gains, compounding value, and equity perpetuity. Let me stress that I don’t claim these constitute canon—these are just my own personal views.

Realizing profits versus compounding value. On one hand, the impulse and instant gratification of realizing profits ironically brings you back to that burden of finding another bargain; on the other, you may have just held onto that stock and let compounding do its magic.

On realizing profits: If the intention is to compound value and amass net worth (i.e. to be rich), then you wouldn't worry about not realizing capital gains. That's the irony in selling stocks—on one hand, by impulse, you just want to realize your paper profits. Realizing your capital gains, however, would again bring you back to that burdening position of finding another bargain (and exposes you to taxes) if you intend to reinvest and further create value. On the other, you may have just indefinitely held onto that stock as long as the underlying business takes care of itself (which in turn takes care of the price). And what is easier and which I personally prefer is the latter case wherein you let the value compound within the business, i.e. that's why I prefer non-paying dividend companies able to retain earnings and compound them at sustainable high rates than businesses paying out all their earnings in dividends (which again exposes you to taxes) at the expense of growth.

Rate of Return on Equity Perpetuity: Dividend Yield and Free Cash Flow Yield

This is Part 2 of a Series. Go to Part 1: Intrinsic Value and the Equity Perpetuity Theory

If we start to think of stocks as perpetuities (i.e. if we intend to be passively enriched as the "equity" perpetuity unendingly pays us flat dough—regardless what the market is schizophrenically doing) then we might as well identify which "equity" annual payments we’d be considering and discounting. Once we identify these, we'll discover that the rate of return on our equity perpetuity is nothing more than two familiar, often used (but also often misunderstood) measures: the dividend yield and free cash flow yield.

Return Measures of the Equity Perpetuity. When we conservatively assume a stock is a perpetuity and try to derive a rate of return, we're mathematically bound to eventually use the Dividend Yield and Free Cash Flow Yield.

If we choose cash dividend payments, then we’re effectively using the dividend yield. If a stock has recently paid out dividends of Php100 and we assume that it’s gonna issue dividends year after year (since it’s been doing that for years already) and we also assume these will be flat, then we'd have to discount Php100 at a rate we'd want to achieve (i.e. 15%). Using this conservative frame of mind, the stock, obviously, has got to be worth Php666.67 (Php100/15%). On a flipside, if the same stock’s trading at Php500 and we bought it at that price level, then perpetuity-wise (i.e. assuming flat payments forever), our rate of return shall conservatively be 20% (imagine: that is regardless whether the market shuts down or commits suicide—you’re just relying on the fundamental dividend-paying capacity of the underlying business). The dividend yield shall be that equity perpetuity yield from a dividend-conscious perspective. Isn't the Dividend Yield more meaningful if taken from a flat-dividend-paying perpetuity standpoint?

Squeezing the Rationale Behind the Price/Earnings Ratio... or at least its Twin, the Earnings Yield

I’m not really a fan of the Price/Earnings (P/E) Ratio.Why would you want to divide the stock price by its earnings, anyway? Have we even really thought what kind of information we'll get from that? Or are we using it just because everyone else is. Let’s be honest.

P/E Ratio & Earnings Yield. The P/E Ratio personally doesn't appeal to my reason. Its reciprocal, the Earnings Yield, however, seems to be more logical. It's very reminiscent of the rate of return of a perpetuity annuity!

Well, I’ve been thinking about it... And the immediate, most seemingly logical explanation I can muster (to justify its use) is this: It essentially computes the breakeven period (in years) it would take to recover that stock price you’d be paying assuming the company continues to flatly produce the same earnings. Doesn’t it make sense from this stand point? But why would you want to know that, anyway?

The only way I can think of to make sense of the P/E ratio is by taking its reciprocal—that is, instead of dividing the stock price by its earnings, we do the opposite—divide earnings by the stock price. Thus, we get the Earnings Yield, P/E’s reciprocal twin. I have to admit I had my initial reservations on using this ratio. But after going through several valuation techniques and further pondering on the DCF approach/analysis, the simplistic rationale behind the earnings yield suddenly lit up!

Intrinsic Value and the Equity Bond Theory

This is Part 2 of a Series. Go to Part 1: Intrinsic Value and Bond Valuation

Equity Bond. A stock can likewise be thought of as a bond whose worth is just the sum of all its discounted free cash flows. The difference from your regular bond being: the equity bond yields expanding coupons!

Following the line of rational thinking usually applied in bond valuation, a business, in the same manner, is only worth all the discounted future cash flows it can provide. A business, therefore, can be thought of as an “equity” bond. The question now is: which cash flows should we consider and discount?

An extreme take on this paradigm is the Dividend Discount model. Taking on the assumption that the significant cash flows are only those dividends actually paid to the shareholders, the model intends to value a stock based only on these dividends. The immediate problem on this extreme view is how detached it is from the real, internal cash-generating capacity of the business. For one, it can be deceptive since dividends by themselves say nothing of the operating realities of the underlying asset—they can even be financed through externally sourced debt at the immediate pleasure of naive, detached “owners”, but at the immense detriment of long-term, business sustainability. Another reason is that, there's also those companies which are really good at making money but are not in the habit of disbursing them as cash dividends. It's not that they don't want to share the profits, but that even the board of directors and the shareholders favor income retention because management is capable of further deploying these profits in investments that would further compound wealth.

FEU’s Cash Hoard. And They Said School is Boring...

This is Part 3 of a Series. Go to Part 2: So Where Have All Those Free Cash Flow Gone?

Majestic Campus. FEU is one of those few quality businesses that routinely produce and hoard free cash for the wealth enrichment of its owners.

I can’t blame anyone who thinks school is boring. Be it on what one may have experienced back in high school or college (e.g. boring classes and teachers/professors), or in stocks (i.e. boring, illiquid issues that hardly move in the market). But let’s take on the shoes of a prospecting investor interested in the fundamental cash-generating dynamics of a school as a business.

Disclosure: I'm currently a shareholder of Far Eastern University—yes, it is listed in the Philippine Stock Exchange (PSE: FEU).

Grasping the core business model of a school seems easy. Schools teach and prepare students for the real world, and in return collect tuition fees for this education service. As many are aware, they collect these fees upfront; before a student can walk into a classroom to learn, he must first pay the registrar a visit and write the accounting department a check. Not mentioning its other sidelines (such as leasing certain properties owned and deploying excess cash into other non-core business investments), that's how a school primarily makes its money.

So Where Have All Those Free Cash Flow Gone?

This is Part 2 of a series. Go to Part 1: The Corporate Cash Hoard Theory

Flow Accumulation. Doesn't the thought of where free cash flow has been accumulating merit contemplation?

A company’s cash hoard is similar to the idea of accounting profits being accumulated in equity’s retained earnings. In this case, however, we're talking money—that is, cold hard cash, not booked accruals, or capitalized expenses. If one is so conscious about observing free cash flow and one subscribes to the idea of it being the true measure of cash profits, the more so should be with how and where it accumulates. That is, that “free cash equity” base where all those free cash has accumulated.

Remember that free cash flow tracks internally-generated earnings realized in cash. That being so, it does not give any bearing or value to booked receivable sales, booked payable expenses, externally sourced cash, as well as prepaid expenses, inventory, and capex assets which are all actual cash outlays. Following this bias on internally-generated cash, the balance sheet accounts can appropriately be reclassified as follows:

ASSET SIDE

• Free Cash Assets – they include cash & cash equivalents and non-core business investments (stocks, bonds, real estate, etc.)—these are the primary free cash flow outlets—the asset base of cash hoard.
• Capex Assets – while these are investments on enterprise infrastructures, these are actual cash outlays.
• Trade Assets – these are accounts receivables (accrued sales which are yet to be collected), and prepaid expenses and deferred tax assets (actual cash outlays).

The Corporate Cash Hoard Theory

This is Part 1 of a Series.

Ultimately, the industrialists, the rich, or the wealthy want to see a certain build-up of cash profits (i.e. free cash flow) in their businesses. This is despite all the demand of large cash outlays to maintain their respective core business operations. They try to achieve and maintain this liquid financial state so they can pay themselves (e.g. dividends, share buybacks) or further reinvest those free cash in other cash-generating assets (e.g. acquisitions of whole businesses, non-core business investments). Like a small seed growing into a large fruitful tree, small humble businesses, producing hoards of cash, turn themselves into large holding companies owning several other businesses. These subsidiary businesses, which eventually produce even more cash themselves, enable the corporate group to acquire even more businesses, compounding wealth at an accelerating speed.

Uncle Scrooge McDuck's Cash Hoard. While the word "hoard" or "hoarding" evokes images of wealth and riches in the forms of gold coins, jewelries, and other valuable/rare items, in the real world of business, these are in the forms of cash, investments in real estates, ownership of businesses/stocks, bonds, and other liquid, marketable assets or other cash-generating assets.

This hoarding nature of excellent, money-making companies can be attributed to their unwaning generation of free cash flow which has accumulated in the midst of the enterprise. Its accumulation, thus, would indicate a business well positioned to propel itself, as it utilize those hoarded free cash to exploit shareholder value-enhancing opportunities.

I will be discussing a self-contemplated financial concept I shall be referring to as “Corporate Cash Hoard” or simply, “cash hoard”, “free cash hoard”, or “free cash equity”. It is a theory which picks up from where the idea of free cash flow left. It is not intended to replace your usual standard accounting/finance balance sheet framework (particularly familiar accounts such as current assets, non-current assets, current liabilities, non-current liabilities); what it intends to offer is a cash-bias perspective on the overall “free cash” financial standing of a firm.

Before you continue reading, I’d suggest you read through my Cash is King blog series. That’s gonna help provide some basic understanding and, hopefully, useful insights on how to visually observe how a business internally generates its cash profits.

The concept of the corporate cash hoard is founded on the idea that: With free cash flow being continuously produced by a cash-generating business, it’s got to be accumulating somewhere in the balance sheet. The question is, where have all those free cash flow gone? Thus, although I would refer to it as “cash hoard”, this shouldn’t be confused with the cash & cash equivalents asset account under the balance sheet. Continue to Part 2: So Where Have All Those Free Cash Flow Gone?

The Money Machine Making Free Cash Flow

This is Part 4 of a Series. Go to Part 3: Showing You the Money and the Natures of Cash Flow

Save the Investing and Financing portions of Cash Flow, Operating Cash Flow just lacks that discerning appeal innate to the Income Statement. You've got certain adjustments which are really confusing, and immediately churned out at the bottom is a net figure; you can hardly decipher where and how cash was made and paid! What we want to see is how the business makes it money...

Seeing the Money Machine in Action. The Direct Method of Cash Flow Statement cleanly illustrates where and how money is paid and made in the business. 

Now imagine an Operating Cash Flow statement which can tell you, spot on, the cash receipts coming in, and cash disbursements going out, in an organized way similar to the kind of intuition you get when you look at the Income Statement. This is the Direct Method of Cash Flow Statement.

So you’re telling me there is such a thing called Direct Method of Cash Flow Statement? Yes. Then why hasn’t this been used in the first place? I’m not so sure myself (I'm curious, too, so you may comment below or message me if you know why). Companies and regulating government agencies seem to prefer the Indirect Method of Cash Flow Statement because of how it readily reconciles with the Income Statement’s Net Income. After all, because of the reconciling adjustments, it actually holds information you need to convert it into a Direct Method. Its proforma just needs a slight overhaul and reorganization to be easily understood. And that’s just exactly what we’re gonna do and demonstrate.

By Sheer Business Instinct, We Know that Cash is King

The Color of Money. Businessmen and entrepreneurs are instinctively money-conscious. They are very mindful of not only profits, but cash profits!

This is Part 1 of a Series.

I've always admired businessmen or entrepreneurs who have not a clue or idea about the stock market, but when they start speaking about their private companies, you can visualize the excellent fundamentals, and cash-generating power of their business models. They have a quick eye on the things that matter—they are mindful of large expenditures and always expect return benefits from cash outlays (such as an investment on an equipment and the potential savings it eventually brings). They hardly talk about accounting profits; instead, they focus on cash flow and return on investment. It’s reminiscent of that business-minded, typical Pinoy concern of "Magkano ba kikitain ko jan?" When you hear him ask that, you know he's concerned about how much cash he will get in the end.

But why has this Pinoy concept of kita been so obscured when it comes to actually evaluating companies listed in the stock market? Perhaps that is the challenge: being able to read, interpret, and translate conventional, corporate financial statements into simple, common-sensible information relevant to a cash-conscious, inquiring businessman investor—more than seeing the accrual side of things, we also try to ask: “Magkano ba talaga ang kinikitang pera ng kumpanyang ito?” and “Saan ba talaga nanggagaling at napupunta ang pera?”