Investing is based on the premise that an asset’s value is the cash flow that it generates over its lifetime, discounted to the present. This applies to all assets classes.

For real estate, the cash flow generated is rent. For bonds, it’s the coupon. For companies, it is profits.

In the case of stocks, investors may use cash flow to the firm to value a company. Let’s call this the DCFF (discounted cashflow to the firm) model. But valuing a stock based on cash flow to the firm may not always be accurate for shareholders.

This is because free cash flow generated by the firm does not equate to cash returned to the shareholder.

Take for instance, two identical companies. Both generate $1 per share in free cash flow for 10 years. Company A  hoards all the cash for 10 years before finally returning it to shareholders. Company B, however, returns the $1 in free cash flow generated to shareholders at the end of each year. 

Investors who use a DCFF model will value both companies equally. But the actual cash returned to shareholders is different for the two companies. Company B should be more valuable to shareholders as they are receiving cash on a more timely basis. 

To avoid falling for this “valuation trap”, we should use a dividend discount model instead of a DCFF model.

Companies trading below net cash

The timing of cash returned to shareholder matters a lot to the value of a stock.

This is also why we occasionally see companies trading below the net cash on its balance sheet.

If you use a DCFF model, cash on the balance sheet is not discounted. As such, a company that will generate positive cash flows over its lifetime should technically never be valued below its net cash if you are relying on a DCFF model.

However, this again assumes that shareholders will be paid out immediately from the balance sheet. The reality is often very different. Companies may withhold payment to shareholders, leaving shareholders waiting for years to receive the cash.

Double counting

Using the DCFF model may also result in double counting.

For instance, a company may generate free cash flow but use that cash to acquire another company for growth. For valuation purposes, that $1 has been invested so should not be included when valuing the asset.

Including this free cash flow generated in a DCFF model results in double counting the cash.

Don’t forget the taxes

Not only is the DCFF model an inaccurate proxy for cash flow to shareholders, investors also often forget that shareholders may have to pay taxes on dividends earned.

This tax eats into shareholder returns and should be included in all models. For instance, non residents of America have to pay withholding taxes of up to 30% on all dividends earned from US stocks.

When modelling the value of a company, we should factor this withholding taxes into our valuation model.

This is important for long term investors who want to hold the stock for long periods or even for perpetuity. In this case, returns are based solely on dividends, rather than selling the stock.

The challenges of the DDM

To me, the dividend discount model is the better way to value a stock as a shareholder. However, using the dividend discount model effectively has its own challenges.

For one, dividends are not easy to predict. Many companies in their growth phase are not actively paying a dividend, making it difficult for investors to predict the pattern of future dividend payments.

Our best guess is to see the revenue growth trajectory and to make a reasonable estimate as to when management will decide to start paying a dividend.

In some cases, companies may have a current policy to use all its cash flow to buyback shares. This is another form of growth investment for the firm as it decreases outstanding shares.

We should also factor these capital allocation policies into our models to make a better guess of how much dividends will be paid in the future which will determine the true value of the company today.

Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life. I don’t have a vested interest in any company mentioned. Holdings are subject to change at any time.

The ultimate goal of management should be to maximise shareholder value. This means returning as much cash (discounted to the present) as possible to shareholders over time. 

Finding the right management team that can do this is key to good long-term returns.

Constellation Software

One of the best examples of a management team that is great at maximising shareholder value is that of Constellation Software. 

Headed by Mark Leonard, the team behind Constellation Software has been consistently finding ways to grow free cash flow per share for shareholders by using the cash it generates to acquire companies on the cheap. Constellation’s secret is that it buys companies with low organic but at really cheap valuations. Although growth is low, the investments pay off very quickly due to the low valuations they were acquired for. 

The consistent use of available cash for new investments mean that Constellation’s dividend payouts have been lumpy and relatively small. But this strategy should pay off over time and enable Constellation’s shareholders to receive a much bigger dividend stream in the future. 

Not only are Leonard and his team good allocators of capital and excellent operators, they are also careful with spending shareholders’ money. In his 2007 shareholders’ letter, Leonard wrote:

“I recently flew to the UK for business using an economy ticket. For those of you who have seen me (I’m 6’5”, and tip the non-metric scale at 280 lbs.) you know that this is a bit of a hardship. I can personally afford to fly business class, and I could probably justify having Constellation buy me a business class ticket, but I nearly always fly economy. I do this because there are several hundred Constellation employees flying every week, and we expect them to fly economy when they are spending Constellation’s money. The implication that I hope you are drawing, is that the standard we use when we spend our shareholders’ money is even more stringent than that which we use when we are spending our own.”

This attitude on safeguarding shareholders’ money is exactly what Constellation’s shareholders love. This reliability is also part of the reason why Constellation has been such a big success in the stock market. The company’s stock price is up by more than 14,000% since its May 2006 IPO.

Singapore Press Holdings

On the flip side, there are companies that have management teams that do not strive to maximise shareholder value. Some hoard cash, or use the cash a company generates for pet projects that end up wasting shareholders’ money. And then, there are some management teams that have other priorities that are more important than maximising shareholder value.

Singapore Press Holdings (SPH), for example, was a company that I think did not do enough to maximise shareholder value. SPH, which is based in Singapore but delisted from the country’s stock market in May 2022, was a company that published Singapore’s most widely-read newspapers, including The Straits Times. The company also owned the online news portal, straitstimes.com, as well as other local media assets such as radio channels and magazines. In addition, SPH owned real estate such as its print and news centre that were used for its media business. SPH also had investments in SPH REIT and other real estate.

In 2021, SPH spun off its entire media arm, including its print and news centre, to a new non-profit entity. Unlike normal spin-offs or sales, SPH shareholders did not receive any shares in the new entity, nor did SPH receive any cash. Instead, SPH donated its whole media segment to the new entity for just S$1. To rub salt into shareholders’ wounds, SPH donated S$80 million in cash, S$20 million in SPH REIT units, and another $10 million in SPH shares, to the new entity. 

After the spin-off, SPH’s net asset value dropped by a whopping S$238 million. The restructuring clearly was not designed to maximise shareholder value.

Management said that SPH had to give away its media segment as selling it off or winding up the media business was not a feasible option given the “critical function the media plays in providing quality news and information to the public.”

In other words, management was torn between the interests of the country the company is in, and its shareholders. Ultimately, shareholders’ hard-earned money was squandered in the process. This was possibly one of the more brazen mishandlings of shareholder money I’ve witnessed in the last decade.

Bottom line

As minority shareholders in public companies, we often have little to no say on how things are run within a company. Our votes during shareholder meetings are overshadowed by other major shareholders who may also have conflicting interests. As such we rely on the honesty and integrity of management to put minority shareholders’ interests as a priority. 

Unfortunately, conflicts of interest do occasionally occur. As an investor, you may want to consider only investing in companies that will protect shareholders’ interests fervently such as the example shown by Mark Leonard.

On the other hand, we should avoid situations where conflicts of interest may encourage the misuse of funds or even promote dishonest behaviour.

Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life. I do not have a vested interest in any companies mentioned. Holdings are subject to change at any time.

In the lexicon of finance, EBITDA stands for earnings before interest, tax, depreciation and amortisation. It is a commonly reported metric among companies and is sometimes used by management teams to make companies appear more profitable than they actually are.

But making certain adjustments to a company’s earnings can still be useful in certain scenarios

In this article, I explore when should investors, and when should they not, make adjustments to a company’s earnings.

Interest expense

One scenario when it may be good to measure earnings before interest is when you are a bondholder. Bond holders need to see if a company has the capacity to pay its interest and earnings before interest is a good tool to measure profitability in this case. 

Another situation to remove interest is when you are an equity investor (invested in the stock of the company) and want to make year-on-year comparisons. Interest expenses can fluctuate wildly based on interest rates set by central banks. Removing interest expense gives you a better gauge of the company’s profitability without the distorting effects of interest rates.

On the other hand, if you are measuring a company’s valuation, then including interest expense is important. This gives you a closer estimate to the company’s cash flow and the amount of cash that can be returned to shareholders through dividends.

Tax expense

Tax expense is very similar to interest expense. If you are a bondholder, you should look at earnings before tax as this gives you a gauge of whether the company can pay you your bond coupon.

Like interest rates, tax rates can also vary based on laws and tax credits. This can result in tax rates changing from year to year. If you are an equity investor and want to assess how a company has done compared to prior years, it may be best to remove taxes to see the actual growth of the company. 

On the contrary, if you are valuing a company, I prefer to include taxes as it is an actual cash outflow. The company’s value should be based on actual cash flows to an investor and tax has a real impact on valuation.

Depreciation expense

Depreciation is a little trickier. Both bond and equity investors need to be wary of removing depreciation from earnings. 

In many cases, while depreciation may not be a cash expense, it actually results in a cash outflow as the company needs to replace its assets over time in the form of capital expenseditures.

Capital expenditures are a cash outflow that impacts the company’s annual cash flow. This, in turn, impacts the company’s ability to pay both its interest expense to bondholders and dividends to shareholders.

In some cases, depreciated assets do not need to be replaced, or they can be replaced at a lower rate compared to the depreciation expense recorded. This can be due to aggressive accounting methods or the assets having a longer shelf-life than what is accounted for in the income statement. In this scenario, it may be useful to use earnings before depreciation.

In any case, I find it helpful to compare depreciation expenses with capital expenditures to get a better feel for a company’s cash flow situation.

Amortisation expenses

Companies may amortise their goodwill or other intangible assets over time. In many cases, the amortisation of goodwill is a one-off expense and should be removed when making year-on-year comparisons. 

I think that both bond and equity investors should remove amortisation expense, if it is a one-off, when assessing a company.

In many cases, intangible assets and goodwill are actually long-lasting assets that still remain valuable to a company over time. However, due to accounting standards, a company may be obliged to amortise these assets and reduce their value on its balance sheet. In these cases, I prefer to remove amortisation from earnings.

On the other hand, on the cash flow statement, you may come across a line that says “purchase of intangibles”. If this is a recurring annual cash outflow, you may want to include amortisation expenses.

Other adjustments

Companies may make other adjustments and report “adjusted” EBITDA. These adjustments may include things such as stock-based compensation (SBC), foreign currency translation gains or losses, and gains or losses from the sale of assets.

These adjustments may be necessary to make more accurate year-on-year comparisons of a company’s core business. However, one exception may be SBC. This is a real expense for shareholders as it dilutes their ownership stake in a company.

While standard accounting is not a good proxy for the monetary impact of SBC, removing it altogether is also incorrect. It may be better to account for SBC by looking at earnings or cash flow on a per-share basis to account for the dilution.

Final thoughts

EBITDA and other adjustments made to earnings can be useful on many occasions especially when making year-on-year comparisons or if you are a bondholder. Removing non-recurring, non-cash expenses such as amortisation also makes sense when valuing a company.

However, there are also situations when it is better to use GAAP (Generally Accepted Accounting Principles) or IFRS (International Financial Reporting Standards) earnings.

Some companies that are loss-making may conveniently use adjusted earnings simply to mislead investors to get their share price higher. This should be a red flag for investors.

Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life. I do not have a vested interest in any companies mentioned. Holdings are subject to change at any time.

Share buybacks can be a powerful tool for companies to boost their future earnings per share. By buying back shares, a company’s future earnings can now be shared between fewer shares, boosting the amount each shareholder can get.

Take Apple for example. From 2016 to 2022, the iPhone maker’s net income increased by 118%, or around 14% annualised. That’s pretty impressive. But Apple’s earnings per share (EPS) outpaced net income growth by a big margin: EPS advanced by 193%, or 19.6% per year.

The gap exists because Apple used share buybacks to decrease its share count. Its outstanding share count dropped by around 30%, or an annualised rate of close to 5.7%, over the same period.

But the power of buybacks is very much dependent on the price at which they are conducted. If a company’s share price represents a high valuation, earnings per share growth from buybacks will be less, and vice versa.

Valuations matter

To compare how buybacks lose their effectiveness when valuations rise, let’s examine a simple illustration. There are two companies, A and B, that both earn a $100 net profit every year and have 100 shares outstanding. These give them both earnings per share of $1. Let’s say Company A’s share price is $10 while Company B’s is at $20. The two companies also use all their profits in year 1 to buy back their shares.

Companies A and B would end the year with 90 and 95 shares outstanding, respectively. From Year 2 onwards, Company A’s earnings per share will be $1.11, or an 11% increase. Company B on the other hand, only managed to increase its earnings per share to $1.052, or 5.2%.

Buybacks are clearly much more effective when the share prices, and thus the valuation, is lower.

The case of Apple

As I mentioned earlier, Apple managed to decrease its share count by 30% over the last six years or 5.7% per year. A 30% decrease in shares outstanding led to a 42% increase in EPS*. 

Apple was able to decrease its share count so significantly during the last six years because its share price was trading at relatively low valuations. Apple also used almost all of its free cash flow that it generated over the last six years to buy back shares. The chart below shows Apple’s price-to-earnings multiples from 2016.

Source: TIKR

From 2016 to 2019, Apple’s trailing price-to-earnings (PE) ratio ranged from 10 to 20. But since then, the PE ratio has increased and now sits around 30.

In the last 6 years – from 2016 to 2022 – Apple was able to reduce its share count by 30% or 5.7% a year. But with its PE ratio now at close to 30, the impact of Apple’s buybacks will not be as significant. If Apple continues to use 100% of its free cash flow to buy back shares, it will reduce its share count only by around 3.3% per year. Although that’s a respectable figure, it doesn’t come close to what Apple achieved in the 6 years prior. 

At an annual reduction rate of 3.3%, Apple’s share count will only fall by around 18% over six years, compared to the 30% seen from 2016 to 2022. This will increase Apple’s earnings per share by around 22% versus the actual 42% clocked in the past six years.

In closing

Apple is a great company that has rewarded shareholders multiple folds over the last few decades. In addition to growing its business, timely buybacks have also contributed to the fast pace of Apple’s earnings per share growth. 

Although I believe Apple will likely continue to post stellar growth in the coming years with the growth of its services business and its potential in emerging markets, growth from buybacks may not be as powerful as it used to be.

When analysing the power of buybacks, shareholders should monitor the valuation of the stock and assess whether the buybacks are worthwhile for shareholders.

*(1/1-0.3)

Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life. I have a vested interest in Apple. Holdings are subject to change at any time.

It is not uncommon to see stock prices gyrate wildly during earnings season. A small earnings beat and the stock goes up 10% or even 20%. An earnings miss and the stock is down double digits after hours.

Are these stock price movements justified? Has the intrinsic value of the stock really changed that much? In this article, I look at how a change in assumptions about a company’s cash flow can affect the intrinsic value of the stock.

I take a look at what effects changing assumptions to a company’s cash flow have on the intrinsic value of the stock.

When long-term assumptions are slashed

Let’s start by analysing a stock that has its long-term assumptions slashed. This should have the biggest impact on intrinsic value compared to just a near-term earnings miss.

Suppose Company A is expected to dish out $1 in dividends every year for 10 years before it closes down in year 10 and liquidates for $5 a share. The liquidation value is paid out to shareholders as a special dividend in year 10. The table below shows the dividend schedule and the calculation of the intrinsic value of the stock today using a 10% discount rate.

The intrinsic value in this case is $8.07.

But what if expectations for Company A are slashed? The dividend schedule is now expected to drop 10% to 90 cents per share for the next 10 years. The liquidation value is also cut by 10% to $4.50. The table below illustrates the new dividend expectation and the new intrinsic value of the stock.

Understandably, the intrinsic value drops 10% to $7.27 as all future cash flows are now 10% less. In this case, if the stock was trading close to the initial $8.07 per share intrinsic value, then a 10% decline in the stock price can be considered justified.

When only short-term cash flows are impacted

But most of the time, expectations for a company should not change so drastically. An earnings miss may lead to expectations of lower dividends for the next couple of years but does not impact dividend projections for later years.

For instance, let’s say the dividend projection for Company A above is cut by 10% for Year 1 but returns to $1 per share in Year 2 onwards and the liquidation value at the end of Year 10 is still $5. The table shows the new expected dividend schedule and the intrinsic value of the stock.

In this case, the intrinsic value drops to $7.98 from $8.07. Only a small decline in the stock price is warranted if the stock was initially trading close to its $8.07 intrinsic value since the decline in intrinsic value is only minimal. 

Delaying cash flows to the shareholder

Expectations can also change about the timing of cash flows paid to shareholders. This will also impact the intrinsic value of a stock.

For the same company above, instead of dividends per share declining, the dividends are paid out one year later than expected. The table below shows the new expected dividend schedule and the present value of the cash flows.

As you can see this has a bigger impact on intrinsic value. The intrinsic value of the stock drops to $5.24 from $8.07. But this is a pretty extreme example. We have delayed all future cash flows by one year. In most cases, our expectations may not change so drastically. For instance, Year 1’s dividend may just be pushed to Year 2. The table below illustrates this new scenario.

In this case, the intrinsic value only drops by a few cents to $7.99.

Conclusion

A change in expectations for a company has an impact on intrinsic value. But unless the expectations have changed dramatically, the change in intrinsic value is usually small.

Fluctuations in stock prices are more often than not overreactions to new information that the market is prone to make. Most of the time, the new information does not change the expectations of a company drastically and the stock price movements can be considered unjustified. This is the case if the stock price is trading close to its original intrinsic value to begin with.

But bear in mind, this works both ways. Stock price pops can also be considered unjustified depending on the situation. As investors, we can use any mispricing of stocks to earn a good long-term return.

Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life. I have no vested interest in any companies mentioned. Holdings are subject to change at any time.