Hi Adam, thanks for the great article. I think the formal name for this approach is the "Grinold Kroner Model". May I request you to share how you arrived at 6.7% annual headwind when the P/E reduces from 20x to 10x over 10 years?
I didn't know it had a formal name! :) Thanks for letting me know. On the 6.7% headwind: A change from 20x to 10x is half or 0.50. You take 0.50^(1/10), which is 0.93 (rounding) minus one is -6.7%. Did I muddle that too much or could you make out my math?
Hey Adam. Great post! In your final example, to calculate the new earnings per share of $0.163 do you take earnings of $150 * (1 + 7.5%) = $161.25 divided by the new share count of 990? If this is so, I’m getting EPS of approx. $0.1629, or an increase of 8.59% (unlike your 8.75%) between original EPS of $0.15 and new EPS using the above formula. Please advise!
You are correct. I went back and did the math and came out with the same answer. I'm not sure what I was thinking or doing. Maybe an interim rounding step caused it or more likely I just go lazy and rounded to a nice even number. Thanks for pointing it out, I'm going to go back and revise it.
You could base it on the change in BV and price/BV, which should come out the same. But in this case we're using earnings and price/earnings. As long as you are consistent the math should work out the same since it's the same company. Unless something funky happened with BV in which case it might not.
I asked this question because imagine a company that keeps its profits the same for the next 5 years, keeps its P/E multiple also the same, and does not pay dividends nor buy back shares, what would be the future return of this company? In this case, I imagine that the retained earnings are increasing the book value, which also increases the value of the company, so in this company, would it be more appropriate to consider the growth of the book value?
Just thinking out loud here, I think the value of the company would rightly remain the same or even decline. A company so envisioned would be using more capital to earn the same amount of profits. Said another way, it would be earning a lower return on capital. The only caveat is if you could point to excess cash accruing on the BS that you were certain would be returned or deployed at a satisfactory return. Your question proves you have to stop and think and reason through what's happening in each case.
Repurchases only make sense when the company stock is undervalued. When they are used to make earnings appear better or for management to cash in on options there is no benefit and is a poor allocation of capital.
Thanks for putting this value out there for us!
Hi Adam, thanks for the great article. I think the formal name for this approach is the "Grinold Kroner Model". May I request you to share how you arrived at 6.7% annual headwind when the P/E reduces from 20x to 10x over 10 years?
I didn't know it had a formal name! :) Thanks for letting me know. On the 6.7% headwind: A change from 20x to 10x is half or 0.50. You take 0.50^(1/10), which is 0.93 (rounding) minus one is -6.7%. Did I muddle that too much or could you make out my math?
Thanks, clear now.
Hey Adam. Great post! In your final example, to calculate the new earnings per share of $0.163 do you take earnings of $150 * (1 + 7.5%) = $161.25 divided by the new share count of 990? If this is so, I’m getting EPS of approx. $0.1629, or an increase of 8.59% (unlike your 8.75%) between original EPS of $0.15 and new EPS using the above formula. Please advise!
You are correct. I went back and did the math and came out with the same answer. I'm not sure what I was thinking or doing. Maybe an interim rounding step caused it or more likely I just go lazy and rounded to a nice even number. Thanks for pointing it out, I'm going to go back and revise it.
Thanks for clarifying. Again, great post.
doesn't book value enter the calculation anywhere?
You could base it on the change in BV and price/BV, which should come out the same. But in this case we're using earnings and price/earnings. As long as you are consistent the math should work out the same since it's the same company. Unless something funky happened with BV in which case it might not.
I asked this question because imagine a company that keeps its profits the same for the next 5 years, keeps its P/E multiple also the same, and does not pay dividends nor buy back shares, what would be the future return of this company? In this case, I imagine that the retained earnings are increasing the book value, which also increases the value of the company, so in this company, would it be more appropriate to consider the growth of the book value?
Just thinking out loud here, I think the value of the company would rightly remain the same or even decline. A company so envisioned would be using more capital to earn the same amount of profits. Said another way, it would be earning a lower return on capital. The only caveat is if you could point to excess cash accruing on the BS that you were certain would be returned or deployed at a satisfactory return. Your question proves you have to stop and think and reason through what's happening in each case.
Thank you.
Repurchases only make sense when the company stock is undervalued. When they are used to make earnings appear better or for management to cash in on options there is no benefit and is a poor allocation of capital.