Over the last several posts, we’ve been discussing the different performance components of a company as a way to predict its investment performance. Evaluating a company starts with business performance, which is based on the decisions management makes over time on allocating its capital to grow profits. Business performance drives shareholder performance—that is, how much shareholders benefit from management decisions. Through their vote, shareholders can impact business performance by ousting senior management if they aren’t performing.
The final component, investor performance, relates to investors’ decisions on how they allocate their capital. While it may seem investors have little input or control once they invest their money, it triggers a sequence of capital allocation decisions by management and the board directors on behalf of the shareholders. They continue to make decisions on how they invest their dividends and whether they want to continue owning the stock. The collective decisions by hundreds or thousands of investors can either drive future returns or send a message to the board of directors that a change is needed.
Investors are in Control
Investors have more influence on a company’s investment performance than they might realize. First, investors are also shareholders, so they have an important role in monitoring the board of directors and voting to seat or unseat its members. But they play another, more critical role that has a more direct impact on investment performance, which is the decisions they make as an investor. Their first decision is to determine what price they are willing to pay for a stock, and their second decision is to determine at what price they should sell the stock. The third decision is what to do with the cash dividends they receive—reinvest them or invest them elsewhere. All these decisions are integral to driving a company’s investment performance.
The Value of Using Multiples in Buy and Sell Decisions
Investors can use a company’s financial data to inform their decisions. When that data is translated into ratios or multiples, it’s easier to set up comparisons and identify trends. A multiple measures a specific aspect of a company’s business performance relating to its financial health. One of the more commonly used multiples is the price-to-earnings (P/E) ratio, which is used to show how much investors are willing to pay per dollar of earnings. Price-to-book value is another widely used multiple to compare a company’s market value to its book value. Then there’s the enterprise value to earnings, similar to the more straightforward P/E ratio but more complicated.
These are all tools investors can use to determine if a stock may be overvalued or undervalued and how it might perform in the future based on current data. Use them wisely, and you can perform well. Neglect them or use them poorly, and you will underperform. Take the P/E ratio as an example.
Say you purchased a stock when a company’s P/E ratio was 30, and the company generated profits for the next ten years. Over that time, profits were returned to shareholders in dividends, share buybacks, and increasing book value. But, when you later sold the stock, the company’s P/E ratio was at five. That means the valuation the market placed on those shares is telling you that what you’re paying should be a lot less than what you’re getting. There could be any number of company-related or market-related reasons why that happened.
The point is that the difference in the ratio from the time of a stock’s purchase to its sale is largely in the investor’s control. That makes the decision a critical component of your overall return or investment performance. In an ideal world, you buy the stock when the P/E ratio is 20 and then sell it later when it’s still at 20. That would mean that 100% of investment performance is driven by business and shareholder performance, which is not often the case.
Using a Margin of Safety to Gain the Edge
In reality, the multiples when you sell a stock are almost always different from the multiples when you bought the stock. Investors can stack the deck in their favor by purchasing the stock when the price multiple is at a discount and then some. This is what Benjamin Graham referred to as adding a “margin of safety.” Graham understood that a stock priced at $50 today could just as likely be valued at $25 in the future as it could be $75. He assumed that its current valuation could be wrong, which would mean taking unnecessary risk. But, if he could purchase the stock at a discount to its intrinsic value, he could limit the downside risk. Because there is no guarantee the stock price would increase, buying the stock at a discount provided the margin of safety he wanted to minimize potential losses.
So, as an investor, you need to look into the company’s history of P/E multiples and how the market valued it over time. You might then be able to determine what the stock’s price should be if it were to sell at a discount based on that historical average. Your job is to wait, patiently, until the stock is trading at that price. That gives you a margin of safety, which increases the chances of selling that stock in the future at a higher multiple than when you bought it. When you sell a stock at a higher multiple than when you bought it, you are actually contributing to the company’s investment performance.
The Dividend Decision
The third decision investors need to make what to do with their cash dividends. Dividends play a key role in a company’s investment performance, and investors control how they are used. If the company is performing well and driving solid investment performance, you probably want to reinvest them back into the company. That drives investment performance further. However, if the multiples become unattractive over time, it may not make sense to reinvest in the company. That should prompt a decision as to whether the stock is still attractive.
Conclusion
When evaluating a company’s investment performance, you need to dive deeply into the performance drivers. That starts with the company’s business performance, which drives shareholder performance. At the investor level, performance is based on decisions on how they allocate their capital, when to buy and sell a stock based on price multiples, and how they use the company’s dividends. To a great extent, investor performance drives both business and shareholder performance. But the three components work in concert like a set of gears, continuously turning, speeding up or down, and, when one gear slows down or gets a kink, it affects the others, which impacts investment performance.
