The Three Engines of Stock Returns

A framework for estimating the rate of return on a stock investment

In investing, simplicity is key. There is limited correlation between the degree of complexity baked into analysis and investment returns. When able, it is best to keep things as simple as possible because the simpler the case, the fewer variables that we need to play out correctly.

“We [Berkshire Hathaway] have a passion for keeping things simple.” - Charlie Munger

Focusing on simplicity, this piece will introduce a framework that identifies 3 engines that drive returns for a stock investment. Our view is that the expected long-term annualized return of a stock can be approximated using the sum of just 3 factors.

Expected Annualized Return = FCF Growth + Shareholder Yield +/(-) Multiple Expansion or (Contraction)

Shareholder Yield = Buyback Yield + Dividend Yield

1) The Growth Engine

A Primer on Cash Flows

As Nick Sleep has previously said, the intrinsic value of a business is the value of all the free cash flow it is expected to generate between now and judgment day, discounted back at a reasonable rate. One school of thought, notably Aswath Damodaran (known colloquially as the Dean of Valuation), contends that the appropriate discount rate to use is the company’s weighted average cost of capital (“WACC”). A second school of thought believes that it is more appropriate to use one’s required rate of return as a universal discount rate, automatically baking in a margin of safety.

However, regardless of which school of thought one subscribes to, a necessary corollary of this intrinsic value definition is that growth is inherently part of the judgment of value and returns. Namely, as investors, the type of growth we should be most concerned with is the growth in free cash flow (“FCF”). FCF refers to the operating cash flow remaining after funding any capital requirements needed to maintain the existing productivity of fixed assets (equipment, machinery, factories, furniture, etc.) and reinvest into growing operations. Formulaically:

Free Cash Flow = Operating Cash Flow - Capital Expenditures

This cash flow has a number of uses. It can be returned to shareholders through share buybacks or via a dividend, can be used to repay existing debt, or can be used to finance M&A.

Back to Growth

History does not repeat itself, though, it often rhymes. But even so, one should not blindly plug in historical growth rates as a way to predict future performance. When forecasting growth, it is crucial to obtain a proficient understanding of the underlying business economics.

Forecasting FCF begins from the top line, i.e. revenue. With a strong fundamental understanding of the businesses’ unit economics, one can potentially model growth through a bottoms-up approach, forecasting future revenues via unit/volume/price growth (or a combination of all of them).

One would then need to assess the margins of the business and have a firm understanding of the company’s cost structure, working capital requirements, etc.

Are margins likely to expand, contract, or stay stagnant in the next 5-10 years? What are the prevailing industry dynamics and how is it likely to trend? Does the business have a defensible moat such that it can sustain high returns on capital over time? These are just some of the crucial questions that one must be able to answer with a relatively high degree of confidence.

However, even if you were to have a high degree of confidence, the accuracy of your forecasts is also subject to the relative predictability of the business and its industry. For example, the quick-service restaurant industry has somewhat predictable cash flows given it is generally resilient even during recessionary environments. On the other hand, the biotech industry is highly volatile given cash flows are often contingent on regulatory processes and subject to maintaining patent life.

The implication of this is that forecasting cash flows is, frankly, hard. In fact, it is impossible to do with 100% accuracy. No one can predict the future. However, as fundamental investors, we can make a directional, relatively accurate estimation of how a business’s economics will trend.

This is why, in addition to obtaining a strong grasp of the business, it is crucial to look at businesses with relatively stable and predictable cash flows, or at least businesses that are within your circle of competence. The greater certainty you can obtain in forecasting the cash flows (though recognizing that it will not be 100% accurate), the better able you are to approximate the long-term annualized return of a stock investment via its growth engine.

2) The Yield Engine

There are two ways that a public company can generate yield for shareholders. The first is through dividends and the second is through share buybacks.

Dividends return cash straight into the pockets of shareholders, while buybacks increase the size of a shareholder’s existing share of the pie by reducing the size of the whole pie.

This engine is the most predictable of the three and, quoting Eagle Point Capital, buying businesses with attractive shareholder yields offers a “high floor” in terms of returns. Dividend yield and buyback yield are simply:

Dividend Yield = Annual Dividends ($) / Market Capitalization

Buyback Yield = Annual Share Buybacks ($) / Market Capitalization

However, the caveat to businesses with a high shareholder yield is that sometimes it may only be attractive on the surface. Returning value to shareholders by way of dividends and share repurchases represents an opportunity cost in that the free cash flow could have been used for other corporate finance purposes (outlined above), reinvested back into the business, or left to accumulate on the balance sheet until an opportunity arises. Also, keep in mind that by the time cash dividends reach your pocket, they have been double-taxed; once at the corporate tax level and again as a capital gains tax.

With regard to buybacks, ideally, they should be conducted when the stock is undervalued - buying back stock when it is overvalued would be akin to lighting cash aflame. However, sometimes companies will still buy back overvalued stock in an attempt to buoy the share price by boosting per-share metrics (making post-buyback valuations seem optically undervalued). This is a characteristic of poor capital allocators. We want Great Capital Allocators who are prudent and intelligent in how they choose to use free cash flow.

3) The Valuation Engine

Ideally, we want to buy high-quality businesses trading at a discount to intrinsic value. If we are correct in our assessment of undervaluation, then the stock will experience multiple expansion during the investment holding period. If we are incorrect, then the multiple will contract. This is the mechanic by which valuation works to boost (or dampen) the rate of return on a stock investment.

Additionally, valuation can also be used as a proxy for shareholder yield. Say a business is trading at 20x FCF. The inverse of that (5%) is the FCF yield. In other words, we can say this business is “trading at a 5% FCF yield.”

Remember that FCF can be used for dividends, share buybacks, debt repayment, and M&A. By using FCF yield as a proxy for shareholder yield, we assume that management will use that FCF for dividends or share buybacks and will earn its cost of capital (otherwise the yield to shareholders would vary from that 5%).

With all of this being said though, it is important to not look at valuation in a vacuum. Growth, yield, and valuation are all part of the same equation that contributes to the returns of a stock. As investors, we need to look at and understand these factors in aggregate.

As an Example

As an example, let us take a look at Restaurant Brands International (QSR) - the franchisor of Burger King, Tim Hortons, Popeyes, and Firehouse Subs. Quoting Bill Ackman:

Growth:

“Longer-term, management believes it can sustainably grow same-store sales at a low-single-digit rate.” - Pershing Square Capital Management 2022 Semi Annual Letter to Shareholders

“…QSR’s unit growth returned to its historic mid-single-digit growth.” - Pershing Square Capital Management 2022 Semi Annual Letter to Shareholders

Yield:

“[QSR] has repurchased more than 3% of its shares outstanding over the last twelve months, which when coupled with its 4% dividend yield, enables QSR to return approximately 7% of its market capitalization to shareholders on an annual basis.” - Pershing Square Capital Management 2022 Semi Annual Letter to Shareholders

Based on the yield engine, QSR has a “high floor” on returns - 7% by way of a 3% buyback yield and a 4% dividend yield. For this 7% to materialize, we need to be confident in QSR’s ability to consistently deliver the same degree of share buybacks and dividends each year.

Based on the growth engine, Pershing Square Capital thinks QSR may be able to grow top-line at ~7% - 9% annually (2% - 3% same-store sales growth + 5% - 6% unit growth). For simplicity, assume that this translates into an equivalent rate of growth for FCF.

Combining these, all else equal, QSR could potentially experience a long-term annualized rate of return of 14% - 16%.

However, all else is not always equal. We need to consider valuation as well. QSR currently trades ~14x - 15x 2023E FCF. Depending on our judgment of intrinsic value, this multiple will expand or contract, which will either enhance or diminish our expected rate of return.

If we think the business is undervalued and that the multiple will expand to 17x from 14x over the next 5 years, then that adds ~4% to our expected annualized return. So, in aggregate, through growth, yield, and multiple expansion, with these assumptions we could potentially expect an annualized return of ~18% - 20%.

We now need to put in the extra work to solidify our understanding of the business and determine if these Engine assumptions are feasible and likely. An 18% - 20% annualized return is amazing, but without seeing a clear and feasible path to get there, it is merely a number and a pipe dream.

A Note on the Long, Long Term

While this Three Engine Framework is helpful to approximate expected returns over the long term (5+ years), we need to be cognizant of another key factor - return on capital. As Munger has previously outlined, over the very long term:

“It’s hard for a stock to earn a much better return than the business which underlies it earns. If the business earns 6% on capital over 40 years and you hold it for that 40 years, you’re not going to make much different than a 6% return - even if you originally buy it at a huge discount. Conversely, if a business earns 18% on capital over 20 or 30 years, even if you pay an expensive looking price, you’ll end up with one hell of a result” - Charlie Munger

In other words, over a 20+ year timeframe, a company’s return on capital is a good approximation of what its stock will have returned. One can do very well by buying a wonderful business with high returns on capital at a fair, or even expensive, price.

---

Sources

• Intrinsic Investing

• Eagle Point Capital

• Compounding Quality

• Pershing Square Capital 2022 Semi-Annual Shareholder Letter

• Nick Sleep Investor Letters