When you’re looking at a potential investment, it can be challenging to come up with a “base case” scenario. There’s so much information to consider, and all of the different variables interact with one another. To get a handle on this and to focus on the “big picture,” I like to use a method that I call “5-Component Investing.” As the title notes, I fixate on five major investing components for a business and security.
On the business side, I look at revenue growth and company-wide earnings growth, which are linked by the profit margin.
Transitioning from the business side to the shareholder side, you have earnings per share growth, which is a function of the change in the share count.
On the shareholder side, you have share price growth (a function of valuation) and total return (adding in dividends).
To give you a better feel for this process, I’d like to highlight the five components for Maryland-based asset manager T. Rowe Price (TROW):
In the above table, I have highlighted T. Rowe Price’s history for the last decade. Note that the numbers reflect what actually occurred to end 2008 as a starting point, along with estimates for this year (with two quarters in the books) for an endpoint.
The share price is measured from the end September 2008 to the end of September 2018. I did this to avoid “cherry-picking” a low point. At the end of September 2008, the share price was ~$54, in the months to come that number would get all the way down to ~$20.
In the first line, you can see that T. Rowe Price’s revenue growth was quite impressive. The company’s assets under management went from $276 billion in 2008 to $1.08 trillion in 2018. In turn, T. Rowe Price grew its top line from ~$2.1 billion up to an estimated ~$5.4 billion for this year.
Moving to company-wide earnings growth, here too we see an impressive growth. Earnings grew by 13.5% annually, easily ahead of revenue growth, due to the company’s net profit margin moving from ~23% up to almost ~32%.
That’s on the business side. Now, let’s move to the shareholder side.
If the number of shares outstanding were to remain the same, company-wide earnings growth would equal earnings per share growth. In T. Rowe Price’s case, the company retired -0.8% shares per annum allowing for just over 14% yearly EPS growth during this period.
That’s an impressive result. Very strong revenue growth was aided by an increasing profit margin and reduced share count.
Interestingly, this was not fully reflected in the share price. As we move to valuation, shares of T. Rowe Price went from trading around ~28 times earnings down to ~15 times earnings. In turn, the share price grew by a compound rate of 7.4% per year. This is still solid, but as we now know, it’s a material disconnect from what the business generated.
Finally, we have the dividend component. Interestingly, T. Rowe Price’s dividend payout ratio has actually been ticking down in the last decade. I say interestingly because that hasn’t been a typical scenario for well-known dividend growth companies. Still, the 1.8% starting yield, coupled with strong 11% annualized dividend growth rate, added nicely to an investor’s overall returns.
All told, an investor would have seen a total return of 8.9% per annum. As a point of reference, that’s the sort of thing that would turn a $10,000 starting investment into $23,500 or so after a decade.
This analysis is helpful. It shows us that revenue and earnings growth, share repurchases, and the dividend were all positive components, while the valuation dragged the investment back to a more “normal” return.
Moving forward, we can use these same components to see whether or not a potential investment looks attractive today:
In this table, I have provided the exact same historical information as presented above, along with a hypothetical “TROW Future” illustration for the next 10-years. This is how I began thinking about the security today.
On the top line, I’m not especially confident. It is true that there is a propensity for growth in this industry – once you are invested with T. Rowe Price, fees tend to grow right alongside assets (and assets certainly have an upward tendency). However, there are pressures in the asset manager world, namely a “race to the bottom” as it relates to overall costs, so I have reflected that to a degree with much lower annual revenue growth.
Likewise, the increase in the company’s profit margin over the last decade has been good for past shareholders, but it becomes more and more difficult to formulate as that base gets higher. Just to give you an example, in order for T. Rowe Price to see the same type of growth from the profit margin in the next decade, you would need to anticipate the current mark of 31.9% jump all the way to ~43.9%. My view is that lower rather than higher margins are possible down the line, and this is also noted above.
On the share repurchase front, T. Rowe Price has exceptional balance sheet flexibility, and the valuation is a bit lower as well. Here, I presume ~-1% annual share count reduction. Put together, these three factors equate to an expectation of ~3.8% annual earnings per share growth – nowhere near what the company achieved in the past.
Of course, we’re only part way through the story. On the valuation front, I used ~16 times earnings (more or less the company’s longer-term average), which is partially justified by the amount of net cash the company has on hand. I presumed dividends could grow a bit faster than earnings.
Put together, these assumptions – moderate revenue growth, a declining net profit margin, ~-1% annual share count reduction, average valuation and ~5% yearly dividend growth – equate to the potential for ~6.5% yearly shareholder returns over the coming decade.
Now, it’s important to keep in mind that this is merely my beginning baseline. There are three important caveats: 1) more work is likely required, 2) this is just one possibility out of a wide range of potential outcomes and 3) your view will differ from mine. Indeed, when you’re working through this process it's important to come up with your own expectations to check back on.
In short, in the past decade, the ~9% annualized return of T. Rowe Price was generated largely as a result of strong revenue growth and a vastly improved net profit margin. Share repurchases and dividends also added a positive, but smaller boost. The only component not working in concert was valuation.
Moving forward, the valuation of T. Rowe Price does not have the same propensity to drag down returns, and the dividend and share repurchases look equally or perhaps more interesting. However, the business side – revenue and earnings growth – appears to be more challenging.
This doesn’t mean that shareholder returns from this point must be poor (marginal business results could lead to reasonable investor gains). However, it does offer a benchmark for thinking about the security with the major return drivers in mind.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
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.