Back to Business Fundamentals

Vaughan-2011-07-16-001
Creative Commons License photo credit: pquan

This is a guest column from my friend J Dwight of Dwight Investment Council on “Back to Business Fundamentals” in light of the recent stockmarket roller-coaster:

Whenever the market tanks, it is helpful to remind oneself of what business fundamentals work and how businesses create products and services and translate revenues into cash that can be deployed to increase jobs and security, and, dare it be said, increase wealth, all of which helps society.

First, it takes savings and capital to create jobs.  Savings is defined as intellectual capital (ideas and innovations), physical effort (hard work or sweat equity), thrift (cost savings and productivity), and capital (land and resources and money and machinery).

Second, in order to create jobs people need to have capital to deploy, and the relative certainty that if they take hard earned money and apply their time, effort and ideas, they have a reason to believe that their capital will be returned and that that capital will earn a return, and it will not be denigrated, thwarted, destroyed, taken or expropriated by governmental inaction, intervention or attack.  Changing the ‘playing field’, the rules of the game or the costs of taxes or regulation destroys the inclination of individuals to even put in the effort to create.

Moreover, the Laws of Physics, and economics, cannot be changed by government fiat.  It is time to assert that the policies of Keynesian Economics operate to destroy this effect in the private sector, especially when continuously used, and, some would say, abused.  The past four years have shown that policies backed by Keynesian Theory have not succeeded and have harmed the United States and the world.  They have no legitimate reason to be continued.

Third, once capital is deployed, and begins to return cash to the inventor/owner/managers of businesses, there are five basic choices:

1)     Invest to develop more ideas and innovations, land and buildings, machinery and equipment, people and products.  (Capital Investment)

2)     Buy an existing stock of capital that is generating an predictable revenue and cash flow stream (Merger and Acquisition, M&A)

3)     Pay more to employees, owners and shareholders. (Increase pay and dividends)

4)     Reduce shares outstanding.  Internally, this changes the denominator part of the earnings per share equation, and also the dividends per share equation meaning that the remaining shareholders can get more of the cash in the future. (Share buybacks)

5)     Pay down debt. If debt were used to develop, or buy a stream of income and cash, then the cash return from the business can be used to pay down debt.  This choice, when completed, has a marvelous effect on free cash flow. When debt is paid down or off, then the cash that had been used for this purpose can be redeployed in any of the other four choices. However, this choice, while in action, does little to actually grow the company or business.  It increases the value of the business by unencumbering the cash flow and assets, but does not actually increase the active potential of the business, only its latent potential. (Debt reduction)

Of the five choices above, the question must be asked about risk and uncertainty?  Empirically, the least risky is to pay down debt; the most risky is to invest to develop new ideas into products or services.  Mergers and Acquisitions can prove to be the most rewarding, or the least effective, depending on the execution of the combination of the companies, their cultures and employees.  Paying more dividends and buying back stock rewards shareholders and employees compensated by equity participation.

When business managers perceive increased risk, they rationally choose the least risky thing to do: pay down debt.  This rational action deceases macroeconomic growth, while increasing business value by increasing cash flow earnings and shareholder return in well managed companies.

Underlying the concept of dividend yield, and shareholder return/yield, are the concepts of return on equity (ROE) and return on investment (ROI).  We won’t get into the application of compound return to these in corporate (or personal) balance sheets here, but suffice it to say dividend yield is a crude (and conservative) approximation of real and relative value to an investor comparing returns among various asset classes.

For example:  The dividend yield of the Standard & Poors 500 is currently about 2.9%, while the yield on the 5 year US Treasury is about 2% (ten year 2.25%)  The historic rate of the S&P 500 to increase dividends is 5%.  Thus buying a solid dividend paying company yielding 2.9% and increasing that dividend 5% annually means that after five years the yield is 3.70% after five years and 4.72% after ten years.  Some high quality dividend paying stocks can be had today at considerably higher yields than the average yield of the S&P 500.  All things relative, if one expects low growth (and low interest rates/inflation) over the next ten years the rational investor would choose sound equities.