Reference will often be made to some acquisition or other being earnings “accretive”. Clearly an acquisition would hardly be made if it did not promise at least to add to earnings per share (EPS) and thus to the value of each share in issue. It may be thought, naively, that the simplest way for a listed company to accrete EPS would be to issue shares trading at a particular superior price/earnings (PE) multiple in exchange for another company trading at a lower PE ratio.
If it were so easy to add wealth by issuing relatively highly rated shares to buy lower rated shares, no recorded differences in PE multiples could survive such an obvious arbitrage. All earnings would then command the same price which obviously has not turned out to be the case.
The reason for the observed differences in PE multiples or earnings yields (the inverse of the PE ratio), or for matter dividend yields, is that an asset, particularly the bundle of assets and liabilities that make up a company, has a life of more than one year. A company may have an indeterminately long life given that company assets may be replaced or added to. Assets with economic lives of more than one year will be valued on their earnings and dividend growth prospects as well as their initial or first year yields.
The more growth in earnings expected over the life of an asset, the more investors will be prepared to pay for the asset. The faster the expected growth in benefits for shareholders, the higher the price paid per share and the lower the first year yield.
High initial yielding assets will be expected to have short lives and / or limited earnings, when compared to lower yielding assets or companies. If the market has correctly priced two assets in a similar sector of the economy and facing similar risks to their earnings potential, their expected returns will be the same, even though the initial earnings or dividend yields may be very different. Buying the company with a low PE ratio that is expected to grow its profits slowly, while selling a part of what is expected to be a fast growing company with a higher PE will not necessarily add value to the shareholders diluting their share of profits. What is gained in the form of the relatively low price paid for the asset will likely be lost in the form of the slower growth in earnings from the cheap asset – cheap for that reason.
Unless the assets bought can be transformed by better management or the value of the combined asset pool enhanced by economies of larger scale – the fabled synergies that may or may not justify an acquisition – two plus two cannot be worth more than four. Adding low PE assets to high PE assets must reduce the combined PE in line with a weighted average of the established assets and the newly acquired assets with different growth prospects.
There is a well known equation in the financial literature used to make this point, the so calledGordon growth model (see explanation at the end of this piece). This equation simplifies the standard Present Value (discounted cash flow) valuation model applied to any stream of expected operating profits that is discounted back to its present value by applying an appropriate risk adjusted discount rate to the flow of expected profits.
Parsing property returns
The model provides yet another example of the no free lunch principle in life. High yields imply short economic lives and vice versa – though one might think otherwise when listening to the managers of SA listed property companies and their shareholders who appear concerned, above all, to avoid yield dilution when acquiring assets. They appear fearful of buying assets that currently yield less than the current yield on their listed portfolio regardless of what may be differently better growth prospects.
Such observations are however made against a backdrop of extraordinarily good returns from listed SA property. Since May 2004 listed property has returned an average 20.7% a year, while the JSE All Share Index provided an annual average return, calculated monthly, of 18.14%. The All Government Bond Index, the ALBI, has generated an average total return, capital gains/losses plus dividend or interest income, of 8.86% a year over the same period.
Property returns were on average less risky than shares, with a standard deviation (SD) of returns of 15.85% a year compared to a SD of share returns of 18.14%. Lower bond market returns were significantly less variable over this extended period than shares or property, with a SD of 5.16. The money market would have yielded about 7.34% a year over the same period, with still less variablity.
The chart below shows how the initial dividend yields have come down since 2008 in company with lower long term interest rates and declining growth in dividends paid. It may also be noticed that recently, while bond yields have moved higher, the initial dividend yield has moved in the other direction, meaning a recent rerating of the Property Index and improved recent returns from property compared to bonds.
The initial JSE Property Index dividend yield averaged 7.54% since 2004 compared to an average 2.75% for the JSE. The growth in JSE dividends has averaged 16.22% a year (despite the global financial crisis) compared to the steady average growth of 7.67% a year in dividends paid by the listed property companies.
Faster growth in dividends from all JSE equities has clearly compensated investors for initially lower dividend yields, when compared to property investors who started with much higher initial yields but were subject to slower growth in dividends received. The result has been similarly excellent total returns.
When we add the initial dividend yield to the growth in dividends realized, we get what may be regarded as an internal rate of return (IRR). The IRR for the JSE over the period 2004-2014 was an average 18.98% a year, while the IRR for SA Listed Property was 15.22%. However these realised returns from holding property rather than shares were significantly less variable in the light of the collapse in JSE ALSI dividends in 2009. The SD for the IRR of the property sector was 5.34 compared to 19.29 for listed shares. Clearly the income streams from property, if not as much their valuations (and total returns) have proved more consistent than JSE equities in general and such predictability of dividend streams must have helped to enhance their appeal.
Within the property sector itself, we tested the proposition that the highest yielding property companies can be expected to generate the highest returns. The method used was to rank all the components of the Index by their initial yield every month and to calculate and compare returns over the next 12 months. No such consistently positive relationship between initial yield and subsequent returns from the individual property companies was found. In fact, initial company yields have had no statistical power to explain differences in the returns realised by the different listed companies.
This result was consistent with the theory that what should matter for investors in property, is the combination of initial yield plus growth in dividends. Initial yield alone or apparent concerns about yield dilution should not be a focus of attention. What matters is the combination of initial yield and subsequent growth.
The Gordon growth model
The Gordon growth model makes the simplifying assumption that the expected growth in operating profits, earnings and dividends is a constant, permanent one. Thus the price(present value) to dividend ratio can be expressed as P/D= 1/(r-g) where r is the required risk adjusted return or cost of capital equivalent to the discount rate and g the permanent growth rate. The equation can be converted to an equivalent PE by assuming a constant ratio of earnings to dividends.
This equation can then be reformulated to infer the permanent dividend or earnings growth rate implicit in current share prices and dividend yields. That is the cost of capital r, is the sum of the interest rate available from a low risk long dated government bond , say of 8% p.a plus an appropriate risk premium. That is, an equity risk premium of an average 4 or 5 per cent per annum, to be added to the bond yield to give the required return. That is r is equal to say 8 (government bond yield) +5 (risk Premium) =13% p.a. Depending on the above or below average risks, the company faces this average risk premium can be added to or subtracted from.
The initial certain first year dividend yield (for example 3% a year) can then be subtracted from the 13% required long run return in our example to give the implied (permanent) growth in dividends necessary if the required return is to be realised over time. In this example g, the annual growth in dividends would have to be at a 10% annual rate to justify an initial yield of 3%. Clearly, the higher the initial yield the lower the expected growth rate in g required to satisfy r, the risk adjusted required returns. Vice- versa – low initial yields will be associated with higher expected growth rates in dividends or earnings.