This should be read after consuming Part 1.
If you had, welcome back. This is part 2 of a deep study of 2023 SAI letter which writes about 6 factors that impact total returns of a stock investment. Of which, we covered the first 3 of the 6 factors and they are:
Factor 1: Dividend Yields
Factor 2: EPS Growth
Factor 3: Changes in PE Multiples
“Factor 2: EPS Growth” is the key driver among the first 3 factors studied. There are several reasons for this. First, a stock can only pay out sustainable growth in dividends (Factor 1: Dividend Yields) if it continues to increase its earnings. That is logical. Second, it’s possible for shares of such a stock to be demanded by the investment community. So, its PE multiples could increase over time (Factor 3).
Therefore, Factor 2: EPS Growth is key to investor’s success.
How to Achieve EPS Growth?
Let’s use A Inc as our case study. A Inc is a Growth Stock that made $100 million in earnings in Year 0. By Year 10, its earnings had increased to $200 million. This is 2x in 10 years. Based on the 2023 SAI letter (page 41), there are 2 factors that would contribute to earnings growth.
EPS Growth = Sales per Share Growth x Margin Growth
Here’s a graph that depicts the relationship between EPS growth & total return:
So now, we have:
Factor 4: Sales per Share Growth
Factor 5: Margin Growth
What is Factor 4: Sales per Share Growth?
Let me explain.
In Year 0, A Inc made $100 million in earnings and issued 100 million shares. So, its earnings per share (EPS) is $1.00. Now, what if A Inc had earned $100 million from generating $1 billion in sales and kept its Net Profit Margin (NPM) at 10%? Essentially, in Year 0, its sales per share is $10.00. Its margin is 10% and this had enabled A Inc to record $1.00 in EPS.
There are 2 ways for A Inc to 2x its earnings to $200 million or EPS of $2.00. The first way is to 2x its sales from $1 billion to $2 billion while keeping its margin at 10% and number of shares at 100 million in that 10-year period.
What is Factor 5: Margin Growth?
The second way for A Inc to 2x its earnings is to 2x its margins if it maintains the amount of sales it generates for the 10-year period. This means, if it keeps sales at $1 billion per annum, A Inc would need to increase its NPM from 10% to 20% in that 10-year period to grow its EPS from $1 to $2.
At present, we learnt that a stock can attain EPS growth by attaining continuous growth in sales (Factor 4) while maintaining or increasing its margins (Factor 5). Such is possible if a stock keeps its number of shares issued at constant. But, for most stocks, their number of shares issued changes over time. Such will change the investors’ ownership in percentage terms of the company (A Inc). This leads us to Factor 6: Changes in Share Count.
Factor 6: Changes in Share Count
Once again, let’s look at A Inc. In Year 0, it made $100 million in earnings and its number of shares issued is 100 million. So, its earnings per share (EPS) is $1.
Supposedly, I own 1 million shares of A Inc which is 1%. So, if A Inc generates $1 billion in sales and earns $100 million, my share is ‘$10 million of A Inc’s sales & $1 million of A Inc’s earnings.
Fast forward to Year 10, assuming that A Inc had 2x its sales and kept its margin at 10%. This means A Inc generates $2 billion in sales and earns $200 million.
But, A Inc raised money from new investors to do so. As a result, the number of shares issued for A Inc at Year 10 had increased to 125 million. Personally, I kept my 1 million shares in A Inc without addition. Thus, do I still own 1% of A Inc? In this case, the answer is obviously a “No”. Instead of 1%, I’ll own 0.8% interest in A Inc at Year 10.
My Shareholdings at Year 10
= 1 million shares / 125 million shares x 100%
= 0.8%
Despite 2x in earnings, the actual EPS growth that I attain is 1.6x due to dilution of shareholdings. Take a look at the calculation below:
The Power of Share Buybacks
Now, here is another situation.
Instead of raising money from investors, what if A Inc reduces its share count as a result of its consistent share buyback activities over the 10-year period? Here, what if A Inc reduces its number of shares from 100 million to 80 million at Year 10? Would I still own 1% of A Inc if I keep my 1 million shares in A Inc?
Well, the answer is nope. Instead, I would now own 1.25% interest in A Inc.
My Shareholdings at Year 10
= 1 million shares / 80 million shares x 100%
= 1.25%
Despite 2x its earnings, the actual EPS growth that I attain now is 2.5x due to its continuous share buyback
activities.
So, this is how Factor 6 comes into making the whole story complete:
Based on the above, investors can focus on finding stocks that:
1. Generate consistent growth in sales (Factor 4)
2. Maintain / Improve margins (Factor 5).
3. Buys back shares consistently with operating cash flows (Factor 6)
The 3 factors will impact Factor 2: EPS Growth, which in turn, will impact Factor 1: Dividend Yield and possibly influence Factor 3: Changes in PE Multiples.
At this junction, we’d covered the theory. In the final part (Part 3), I would write a case study to share how the 6 factors come together to multiply & compound wealth of stock investors. Stay tuned for it.
Resources:
Semper Augustus Client Letters
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