The Only Reason to Invest
Nikhil is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
The True Purpose of a Business is...
To produce earnings for its owners. As owners put in the capital and take on the business risk they deserve to reap the rewards of a business's success. That’s the inherent reasoning of owning a stock, and it’s something that many companies ignore even as they say they are “seeking to create long-term shareholder value.”
Since the goal of a business is to return profits to owners, the ultimate goal for business managers should be to either 1) return cash in the form of dividends, 2) repurchase shares when the stock is cheap to increase dividend paying power, and 3) invest and increase earnings as much as possible to increase the dividend paying power of the business.
That’s become more and more clear to business owners as we see Apple Inc. (NASDAQ: AAPL) instituting a new dividend and an anti-dilution share repurchase plan. Similarly Dell Inc. (NASDAQ: DELL) is instituting a new dividend plan that should yield about 2%. It’s clear to the market what the reasoning behind dividends is. Dividends are tangible and income-producing, and dividend yields are a clear and easy method to drive up the stock price.
Share repurchases, however, don’t give back tangible cash to shareholders, so the only result of share repurchases that shareholders see is the resultant increase in earnings per share. This is especially frightening in companies where the EPS is increasing, but net income is decreasing. For share repurchases to be logical, the future dividend paying power of the stock has to be greater than the value of the share on the market. It’s really the basic principle of Value Investing. Management has to be repurchasing their shares for 75 cents on the dollar or it isn’t a smart investment of their cash. If management is paying $1.50 per dollar of their shares, while EPS does increase, it may not be worth the loss of 50 cents that could have been paid as a dividend to shareholders. You’ll notice, for example, that Apple is refraining from extensive share repurchases other than to avoid material dilution of shareholders.
The biggest issue in current businesses, however, is that growth companies don’t correctly apply the third goal: Invest and increase earnings as much as possible to increase the dividend paying power of the business. Generally, growth companies, and managers of growth companies, think their goal is simply to increase earnings as much as possible. Remember the fraud at Diamond Foods (NASDAQ: DMND)? The company was accounting for revenues before they were supposed to, so earnings at the time were higher than they should’ve been, but earnings in the future would eventually have to be sacrificed. The problem with this mindset (other than the obvious part … fraud is bad) is that the goal shouldn’t just be to increase earnings, it should be to increase sustainable earnings. If the goal of a business is to return profits to shareholders, if the business has earnings go up from $1 to $100 and then drop back to $1 before dividends begin, all the investments in growth have just been a waste of time for investors, since the dividend paying power of the business was never actually increased. The key to increasing the dividend paying power of the business is to build sustainable earnings, which means that while a company is growing they should also keep in mind how they’re going to guard their earnings from competition. Now it’s pretty clear why that competitive advantage Buffett always talks about is so important.
So ultimately, the business cycle should look a lot like this:
Essentially, this means for the business owner, investments into growth companies that won’t be able to sustain their earnings is not advisable.
I would put Apple in a transition from High Growth to Stable Growth, while Dell is moving into Maturity, where real shareholder value will come from future increases in the dividend and well-timed share repurchases (Dell recently instituted a share repurchase, although the results are controversial).
Two Polar Opposites
OpenTable (NASDAQ: OPEN) is an online reservation company with arguably no real competitive advantage. Shares have fallen from $115 to $39 on fears that Google will enter the online reservation industry, and in my opinion those fears are more than justified. OpenTable has high earnings now, but it has no reasonable expectation of retaining those earnings as its industry has an extremely low barrier to entry.
Meanwhile, International Speedway Corp. (NASDAQ: ISCA) has an extremely sustainable revenue stream from the motor sports industry because competition would have to invest so much money in infrastructure to even have a chance of competing with it.
The Key to Profitable Investing
If you want to succeed in investing, you should always keep in mind the long-term goal. You own a business, so at some point you should expect some cash to be returned to you. If you look for growth businesses with sustainable revenue streams or mature businesses that are increasing dividends, you’re on the right track.
shamapant owns shares of Apple. The Motley Fool owns shares of Apple and has the following options: short OCT 2012 $40.00 calls on OpenTable and long OCT 2012 $40.00 puts on OpenTable. Motley Fool newsletter services recommend Apple, International Speedway, and OpenTable. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. If you have questions about this post or the Fool’s blog network, click here for information.