Even though we all know that a company's past results do not guarantee a company's future returns, and even though it is impossible to predict the future with precision, we can make intelligent estimates about the future returns of a particular investment that we contemplate.
For instance, let's take a look at a utility company that I happen to admire, Dominion Resources (NYSE:D).
The company is trading at about 20x its current earnings power (that is to say, it is generating $3.15 in normalized profits for current shareholders, and you have to pay $64 per share to get your hands on that starting earnings base).
But there is a catch: the company's dividend payments and debt requirements consume a big chunk of those profits.
As of this writing, Dominion Resources is sliced up into 577,676,451 pieces that generate $3.15 in profits, for total company-wide profits of $1.81 billion. To generate that 3.48% dividend yield that you could get at current prices, Dominion Resources has to pay out $1.29 billion of that profit to current shareholders this year, giving the company's management $520 million in net profits.
But when we look on the horizon, we can see that Dominion has $9 billion in debt owed over the next five years, relative to a long-term debt base of $17 billion that is forcing the company to pay just shy of $900 million in long-term interest.
To achieve modest growth, Dominion Resources has to routinely issue new shares and dilute existing shareholders because it does not organically generate the profits necessary to grow, pay its dividend, and pay down its debt simultaneously (and this is a common condition for many utility companies). That is why the share count has increased from 570 million in 2011 to 576 million in 2012 and an estimated 581 million by year end.
I mention these things not to predict a doom-and-gloom existential threat, but to point out that the deck is stacked for Dominion Resources to achieve returns of 5% over the next decade rather than 10% over the next ten years, given the demands on its current profits and Virginia Power's trouble growing electric sales.
If you were to buy shares of Dominion Resources today, you would be engaging in what I call "investing with a lid on" because it is almost pre-determined that shareholders will not achieve returns around historical market averages of 10% over the next decade. The current P/E ratio of 20x earnings is something that has only happened for an annual period three times in the past two decades, the profits are consumed by debt and dividends, and a platform for high earnings per share growth is not particularly evident--it seems unwise to pay a historical premium for a safe utility under those circumstances.
Instead, I like to engage in what I call "investing without a lid on" to describe circumstances where a company's current growth prospects relative to current valuation gives you a healthy chance to benefit from total returns in excess of 10% in the next decade.
I'll give a few examples.
You might want to take a look at Becton Dickinson (NYSE:BDX). The company has grown earnings by 12.5% annually over the past decade, and grown dividends by 15.5% annually over that time frame. The company has returns on shareholder equity of 23.5%, only has to pay out a third of its profits in the form of dividends, and has reduced the share count from 243 million in 2008 to an estimated 193 million by 2013's year end. I think the current 7% sales growth figures represent untapped energy given the array of problems in Japan resulting from the loss of funding in response to austerity measures. If you could buy in the low $90s, you're putting yourself in good shape to cross the 10% annual mark.
And then there is BP (NYSE:BP). The company is historically undervalued (before the financial crisis and oil spill, a 5% starting dividend yield was considered manna from heaven with this stock). The basic story is this: the company has had to sell off assets to pay for its litigation, and despite the assets sold, the "new" BP is still slated to make over $18 billion in profit next year. In terms of proven reserves, they are sitting on 4.5 billion barrels of oil and 33.3 trillion cubic feet of natural gas. When you start counting joint ventures and side projects, you add another 5.4 billion barrels of oil and 7 trillion cubic feet of natural gas.
When you combine 11% earnings per share growth expectations with historical undervaluation, you are putting yourself in the situation to benefit from returns in excess of 10% annual. Plus, you get a 5% starting yield, which acts as a nice lubricant if you reinvest your shares at this lower valuation and see them expand like coiled springs when the valuation becomes more rational. Buying at today's prices of $40-$43 ought to put you in a position to reap 10%+ annual total returns.
And, if you are willing to move beyond dividend stocks when a company's management demonstrates competence in handling retained earnings, it could be worth taking a look at AutoZone (NYSE:AZO). The company has a realistic possibility of achieving 15% annual earnings per share growth over the next 5-10 years because the company combines organic company-wide growth with a relentless buyback program that is arguably more shrewd than what IBM (NYSE:IBM) is currently doing.
At AutoZone, gross profits currently stand at 51.8%. The company is undergoing very heavy expansion in Mexico, with Brazil possibly next on the list. The company may soon grow from 4,600 to over 5,000 stores in the U.S., generating a combined net profit margin of 11.0% (which is the highest it has been since the late 1990s). The magic occurs when you mix that kind of organic growth with a large, non-stop buyback program. The share count has declined from 152 million in 1998 almost 34 million today.
Think of it like this: imagine 15 guys owned AutoZone in its entirety in 1998, with each of the fifteen people owning equal shares. By the end of next year, the entire company's profits will only be divided between three guys because the other 12 got bought out along the way. It's one of the few living, breathing case studies showing when the theoretical hype and promise of share buybacks actually match the reality of share count reduction often prophesied.
And lastly, there is Chevron (NYSE:CVX). This is on the short list of high-quality, blue-chip dividend companies that I do not yet own. Barring a substantial bust in the pricing of commodities, I would be very surprised if Chevron did not cross the 10% mark for investors that buy below $105, reinvest the dividends, and hold for ten years. The share count is steadily declining. The dividend keeps marching up. The company's LNG projects at the Wheatstone and Gorgon fields are going to start accelerating the earnings per share figures in the next couple of years, and the company is taking advantage of higher natural gas prices abroad to offset unexpected oil weakness here in the U.S. You got a base earnings growth of 8-9%, which will get aided by a billion-dollar buyback program, and when you mix in a growing dividend, you are positioning yourself for nice long-term wealth creation.
Long-term investing is all about surveying the landscape and developing probabilistic earnings growth expectations in relation to the price you pay today. With something like Dominion Resources, the valuation is currently high and the debt and dividend requirements seem to suggest a likely range of 3-6% annual growth. That puts a lid on your investing potential. The key is to find "lidless" investments-and the best place to look for that is when you combine 8%+ company-wide growth with a strong buyback program, which is often accompanied by a growing dividend that can add 1-3% annually to your total returns, depending your reinvestment price.
Disclosure: I am long BP, BDX, IBM. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.