Thursday, June 30, 2005
While reading the comments of one of our readers, I realized that one of the problems of computing a valuation for any investment is the problem of complexity. It is virtually impossible to determine internal rate of return, compounded rate of return, or any other rate of return without a financial calculator. But using a financial calculator is sort of like turning water into wine: its water one moment, the next its wine. And the distance between understanding water and understanding wine is a million miles apart. I try to do all mathematical calculations related to rates of return in my head. It may seem too simplistic, but since the actual rate of return of any investment can only be calculated in hindsight, I think doing the numbers in my head is close enough, and it is intuitive instead of the water to wine abbra kadabra of using calculators. As we go, I will share with you the many rules of thumb methods for determining rates of return, etc., that I use. Let's start with the golden goose example. The goose was laying 20 eggs per month at $400 per egg. The goose was expected to live 5 years so the ultimate value of all the eggs is easy to determine: 20 X 400 X 60 = $480,000. The problem is a stream of income that totals $480,000 that we will receive over the next 60 months is not worth $480,000 today. A financial calculator can easily reveal that the present value of 60 $8000 payments is $417,000. But let's face it how many of us carry a financial calculator around with us. I have found that it is very helpful to possess a few rules of thumb methods to determine the present value of a future stream of income. The one I use most often is the following. In the case of the golden eggs, what is the average amount of money I will have during the 5 years? I start at $0 and end at $480,000. The average of the two is $480,000/2 = $240,000. That number is important because knowing it we can compute a rough approximation of the time value of money. To do so, we multiply the $240,000 times 6%, which we stated earlier was the cost of money. That means that the annual cost of money is $14,400. Since it will take 5 years to produce the $480,000, we multiply $14,400 by 5, or $72,000. We then subtract the $72,000, which is he total cost of money for the 5 years from the total amount we expect to receive of $480,000 and we have a rule of thumb present value of $408,000. Remember, the calculator computed that the present value was $417,000, so our short cut methodology is understating the present value, but in this case, I think it is close enough. Be sure to think through this way of determining the time value of money because in some of the forthcoming examples I am going to go over, I will use this rule of thumb, or short cut means of quickly determining present value. Have a happy Fourth of July and may the Lord bless you and your family.
Saturday, June 25, 2005
At the beginning of trading on Friday June 24, if you would have looked at Bank of America in the Wall Street Journal or other financial media, you would have seen the following: Price Dividend Yield $46.60 $1.80 3.86% During the day, BAC announced an 11% increase in their annual dividend. As the market opens on Monday the 27th the Wall Street Journal will look like this: Price Dividend Yield $46.75 $2.00 4.28% A remarkable event occurred that will be almost completely missed by 99% of investors. BAC increased their dividend by 11%. However, at Donaldson Capital Mgt., it is as though the heavens have opened and someone threw out some stone tablets guiding us toward successful investing. Here's what the stone tablets are saying to us. 1. BAC, which is a nationwide financial services company, is giving us our cut of their profits for the last 12 months. That seems fair and not unusual, but in our judgment only about a fourth of the companies in the S&P 500 pay a fair dividend. 2. In increasing their dividend, they are signaling to us that they believe they can continue to grow earnings and dividends in the low double digits. Wall Street estimates for earnings growth are more in the 9% level. In our minds, BAC is saying to anyone who wants to listen, "We are going to grow faster than the street thinks." 3. BAC is saying we know the future is uncertain, indeed, our whole business is built on lending money to people taking chances, which might fail, but we believe economic growth and corporate profits will continue their current trends. In a manner of speaking, you can say we have bet the whole company on it. 4. If you buy our stock, we believe you will make somewhere near 15% per year over the next 5 years. You will notice I do not have quotes around this last comment, because BAC did not say it, but simple math shows us that a 15% compounded return is the end result of everything else they are saying in raising their dividend by 11%. Here is the simple math: If BAC's dividend grows at 11% per year over the next 5 years, they will be paying a dividend of $3.40 in 2010. To determine BAC's price might seem like a big stretch, but I believe those stone tablets tell us the very best guess is that the stock will trade for at least $84.25. To compute this price all I am doing is dividing BAC's projected 5-year dividend of $3.40 by 4%, which is BAC's average dividend yield over the last 5 years. A person can debate this simple method of determining expected price all they want. But BAC is one of those companies that has had a very predictable dividend growth pattern and the statistics and the odds greatly favor the outcome I have put forward. But, you may ask how do we make 15% when the dividend is only growing at 11%. It's simple, the dividend yield is starting near 4% and combining the 11% annual dividend growth, which based on the historical data will mean that prices will also grow at about 11% per year, we arrive at a total return of 15%. I really believe you must grab hold of this concept of "implied return." This is the best way to make decisions about stocks with your head instead of your emotions. We have used BAC as an example many times. It is a favorite of ours, but we will discuss in an upcoming article a few companies in our portfolios that have as high as a 17% "implied rate of return. Now pause for a moment and consider the alternatives. a 5-year Treasury bond is yield 3.5%. I don't know about you, but 15% with some modest risk sounds a whole lot better to me that 3.5% with no risk. Let me say that again: 15% with some risk sounds a whole lot better that 3.5% with no risk.
Friday, June 17, 2005
The farmer's wife heard the young man's proposal for the goose and she agreed with her husband's refusal to sell half the goose. She knew they had a good life and she understood that the golden strategy wasn't good for anyone except the young man from Wall Street. However, after his dust had cleared the trees, she approached her husband and said, "If the young man would have offered you a million dollars for the goose and said he was going to put it in a box and go away, would you have sold it? Her husband hesitated and then laughed, "I would have sold it for far less. As I was listening to him, I was trying to figure out how much it might really be worth." The farmer's wife said, "I was trying to figure the same thing. We know from experience the goose lays more eggs in a year at a rate of 20 per month than at 30, so her value would actually go down with his first idea. We can't really do much about how long the goose lives. Maybe we could have those Purdue people come in to give us their thinking on what we can do to keep her healthy, but I think couping her up all by herself would kill her quick. That rooster she fancies might have as much to do with the golden eggs as she does. The one thing that the young man said that makes sense, though, is that the price of golden eggs might start to go up as more people decide they want one. " "That's the notion that came to me as well," said the farmer. "Figuring the present value of the goose's future egg production was easy when we kept everything still. But when we start increasing the price of the eggs, it get's a lot tougher to figure. But we really need to find a way to do it because somebody else will soon come down that road and what to buy the goose." "I'll swan to goodness," said the farmer's wife. "The young man said he expected the price of golden eggs to increase by twice the rate of inflation. Today's paper said inflation is increasing at 3%, so he must believe golden eggs will go up 6% a year. That's the same as the rate the banker said to discount future egg prices for the cost of money. That would mean that the growth in golden egg prices would wipe out the cost of money and leave us with a simple calculation: 20 eggs a month times $400 per egg, times the 60 months that we expect the goose to live. That would mean if golden egg prices grow at 6% per year, the present value of the goose is $480,000 (20 eggs/mo. X $400 p/egg X 60mo). The farmer scratched his head and said, "So the intrinsic value of the goose to us is based on what we can get out of her discounted by the cost of money, and that is about $480,000." "But what about the young man's million dollar deal. Is there no truth to it at all?" she said." "It is not real to us because we would not want to be a part of that kind of deal, but somebody else, who doesn't mind taking advantage of his partners, might come along and make an offer approaching the young man's price. If someone wants to pay a lot more than the $480,000 and it's a clean deal and we can walk away, the goose is theirs." "Pappa, we could move to Florida and buy one of those fancy condos on he beach. They are hotter than our golden eggs." "Mamma, I don't think that would work. That smart young man said he was going to Florida for his next deal. Judging, from the deal he showed us for the goose, I would not want to be on the other side of his arithmetic."
Wednesday, June 15, 2005
The young man wandering around in the front yard turns out to be an investment banker from Wall Street. He comes right to the point. "I am here to make you a wealthy man. I have studied your goose. She produces 20 eggs per month. I have consulted experts at Purdue University who say that she can easily produce 30 eggs per month. In addition, if we take her out of the barn yard and put her in a place with proper sanitation and purified air, she can live 7 years instead of 5 years. Futhermore, golden eggs are becoming a hot item. I think we can expect their price to grow at double the rate of inflation. When I add it all up, I think your goose may be worth a million dollars." "Are you offering me a million dollars for the goose?" (remember my calculation said the goose was worth about $417,000) "No, a big part of the higher value of the goose that I project is dependent upon you staying on as the manager of the operation. But, a golden goose like yours needs a golden strategy to maximize its value. My strategy is to sell 49% of the goose to East and West coast investors. As I said your golden goose is getting a lot of attention, and the novelty of it is really creating a buzz. The bottom line is you can pull out $500,000 in cash, less my commission of $50,000, and still control over 50% of a million dollar goose." "Can you really do this?" "This is my business. I do it everyday. I have documents here for you to sign, and a check for $50,000 as a down payment on the deal. I can have the whole transaction done in 30 days. You will just need to work with my experts from Purdue on producing more eggs and constructing a more environment controlled facility for the goose." "Purdue, there's a fine institution. That's where I was going before this goose started laying the golden eggs. I like those Purdue people. They seem more, well, down to earth than some other college types. But, if those people from Purdue, are telling you that this "golden strategy" of yours will work on my goose, they are as crazy as those guys from Indiana University who told me I could reap a fortune by just killing the goose and taking out all the eggs at once, instead of getting only one per day. I don't need Purdue to tell me that my goose can lay 30 eggs per month. She did that for years, but she kept coming down with about every disease in the book, which would put her out of the egg-laying business for long periods of time. I purposely keep her production at 20 eggs per month because I find with the additional rest she actually produces more eggs per year." "You mean you would turn down the opportunity to pocket $500,000 and still control the goose. I don't think you understand what you are doing." "No, I understand exactly what I am doing. I am in the golden egg business. Experience has taught me that to maximize profits in my business, the single most important thing I can do is to do right by the goose. Your "golden strategy" will kill the goose just as surely as cutting it open. I know what the goose is worth, and sooner or later your East and West coast clients will find out that they have overpaid, and they will come out here in big cars and start to tell their "partner" how to run their business. All the extra money you say would come my way would ultimately bring me nothing but misery. I would get to know my attorney better as we make the acquaintances of the attorneys of your clients, who will conveniently forget all the places they signed saying they understood that they were taking a risk. I think its best that you keep your golden strategy and I'll keep my million dollar golden goose.
We want to welcome all the clients of Donaldson Capital Management to our blogsite. We hope you enjoy the rest of the Summer Stroll. Please begin at Summer Stroll # 1 and work your way up to the current article. This discussion of dividend investing is wide ranging yet very specific. We will be discussing in detail how we arrive at purchase decisions. Unfortunately because this site in now open to the public, we will not speak in great detail about why we like one stock over another one. The Summer Stroll is to help you acquaint yourself with how to think about what dividends mean to the investment process and how we came to understand their significance. Please ask any questions that come to mind. That is the best way to understand what we are saying and also it is the best way for us to find out where you are in your understanding of the determinants of the intrinsic value of a stock. The Stroll continues, Greg Donaldson
Monday, June 06, 2005
Did you every stop to think what the goose that was laying the golden eggs was worth before the farmer killed it? Remember in the folk tale, the goose was laying one egg per day of fine, pure gold. The greedy farmer wanted more than one egg per day, so he killed the goose and opened her up expecting to see a belly full of gold. But on the inside the goose was just like all geese: there were no eggs, and the farmer's foolishness has lived on in infamy. We consider many of our Rising Dividend companies to be similar to the goose in their abilities to produce golden eggs in the form of earnings and dividends growth. Having learned from the farmer's folly, we are content to take the eggs as they come. We consider ourselves to be in the business of collecting the golden eggs. We are not about to kill the goose to see if we can squeeze out a few more eggs. We think the goose is doing just fine. Furthermore, we do not jump from goose to goose trying to pick up an extra egg here and there. We have studied the ways of the goose we own, and we think she is the real thing. If we were in the business of trading geese, the next goose, or the one after that might be a turkey that is painting her eggs, and we would lose all that we have gained. We work hard at valuing the goose's future stream of golden eggs. The market for golden eggs comes and goes, and every once in awhile a fool, on the order of the farmer, comes along who thinks he can squeeze more eggs out of the goose; and he is willing to pay us far more for the goose than our calculations say she is worth. This is the great benefit of being in the golden egg business instead of the goose trading business. It is relatively easy to calculate the present value of the eggs over the remainder of the goose's life, while it is very difficult to figure out what the goose is worth based on its color, size, type, or beauty. In these matters of style, our guess is no better than anyone else's. But when it comes to valuing the future stream of golden eggs, we have that down to a science. Let's say the average goose lays 20 eggs per month and produces eggs for 5 years. Each egg weighs about one ounce and gold is selling for about $400 per ounce. Figuring what the goose will be worth over its expected life is easy. It is just the number of eggs per month (20) times the price of gold ($400) times the number of months the goose will lay eggs (60) = $480,000. But things get a little tougher when we realize that it will take us 5 years to produce the $480,000, and to calculate a present value, we need to take into consideration the time value of money. We all know that a dollar we get today is worth more to us that a dollar we will receive 5 years from now because if we get the dollar today, we can invest it, and in 5 years it will be worth much more than one dollar. Because of this, we must discount the $480,000 that we expect to receive by some appropriate interest rate. Let's use 6%. The present value of a monthly stream of gold over the next 5 years totally $480,000 is approimately $417,000. The market for geese can careen all over the place but we don't care because we know what our goose is worth on the basis of the stream of golden eggs. There are only about three things that can affect the value of the stream of eggs: 1. the health of the goose, 2. the price of gold, and 3. the interest rate we are using to discount the future stream of income. Certainly one or all of these things will change, but as they do, we will just change our formula and recalculate the present value of the golden eggs. But, there is a guy in the yard, who say he wants to make an offer on our goose. We'll see what he has to say next time.
Thursday, June 02, 2005
People argue with us all the time about relying on dividends. Once while I was discussing our investment strategy with the CEO of an insurance company, the guy just got up and left. On his way out, he said he was not interested in an investment style that was so conservative. He said he wanted to make the highest rate of return he could, and he believed our approach aimed way too low. I asked him what his target rate of return was, and he said, "As much as I can get." I told him in my years of following the dividend approach, I had always been surprised that it had consistently made more than I thought it would. I suggested he may want to hear me out, perhaps because these surprisingly good results could measure up to his "All I can get" goal. But his mind was made up and I found my own way to the door. There is a new name on the door of the building the insurance firm was in. I don't know what happened to the company or the man, but I do know that he was trying to emulate the success of Conseco, which at that time was a hot shot Indianapolis-based insurance firm. That turned out to be a disastrous strategy. Conseco's hot streak went cold when it was forced into bankruptcy in the 1990s as a result of a string of "as much as I can get" investments that appeared to vaporize as fast as they were made. One horn of the beast we must ride is greed, the other horn is fear. Unless you know what you are doing, you will find yourself making investment decisions out of one horn or the other, and not out of the area between the two horns. Valuations matter and if you don't know how to value an investment, by default, you will find yourself thinking out of your emotions. Greed and fear are terrible partners in any investment. They will never give you peace, and in your saner moments, you will realize that you must have been out of your mind to have invested in this tech stock or that real estate venture--and of course you were. Your adversary is not the investment beast you attempt to ride. Your primary adversary is you: Your emotions, your politics, your understanding of the nature of the beast. The sum total of everything you are and are not will be laid bare in the investment arena. And, in the end, you will reap what you sow. The dividend approach is a very narrow path that you may follow. It is a place where you can sow reason and reap what is reasonable. It is a sane place, where horns must be checked at the door. It is a place where you mostly wait, not a boring wait but a hopeful and exciting wait like an expectant father.