Value Investors = Business Owners. Here's The Irrefutable Accounting Proof.
“How can you value investors call yourself REAL business owners when you're just trading stocks?” — An actual conversation.
CHAPTERS:
1. Retained Earnings = Cumulative Lifetime Investment by Shareholders
2. ROE = Shareholder yield
3. Earnings Yield = True shareholder yield
4. Tying it all together: How a Stock Investment = a Business Investment
5. Value Investing = Picking Stocks Like Billionaires
6. What "15% CAGR Over 5 Years" really means"When I buy a stock, how are my funds directly invested into the underlying business?"
Many people ask (rightfully) how there is even any relationship at all between their stock market purchase and directly investing into the business whose stock they are buying (e.g. Apple) — besides through dividends or at the IPO stage. When you buy a stock of a company on public markets, your funds do not get “invested” directly into the company, but rather go to some 3rd party instead. If so, how can we truthfully call our stock purchase “investments”?
This lack of transparency makes it difficult for many buyers of stocks to subscribe to the idea of being business owners, since they cannot directly relate their stock purchase to profits from the underlying business — other than through arcane financial formulas and dividends. And since value investing proclaims to be all about investing in the long-term prospects of the underlying business — rather than trading paper profits — I think this is an extremely fair question.
In this article, I will satisfactorily address how value investors are indeed business owners by using highly objective financial data to demonstrate how your funds flow directly into the underlying business when you purchase its stock. We will also see how value investors view themselves as participating directly in the profits of the underlying business. In other words, we will see with utmost clarity what it means to be a value investor.
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Retained Earnings = Cumulative Lifetime Investment by Shareholders
Summary:
Scenario 1
1. Net Profit -> Retained Earnings (RE)
2. RE - dividends paid = RE less dividends
3. Same dividends reinvested back into company by same shareholders. Company issues new shares in exchange for investment = Share capital+
4. End result: Share capital+ and RE- but no difference to Total Equity
Scenario 2
5. If company never paid dividends, same end result to Total Equity.
6. Only difference is dividend amounts remains in RE, instead of being moved to Share capital.
Conclusion:
8. Most of Total Equity = RE = Cumulative lifetime investment by shareholdersTo begin, let’s set some context. Most people are familiar with how a company’s annual Net Profits flow to Retained Earnings on the company’s balance sheet. After deducting dividends paid, the remainder of Retained Earnings are reflected in the following year’s balance sheet. Hence, the Retained Earnings of a company represents its cumulative Net Profits after dividends since its inception.
The Retained Earnings of most mature businesses (e.g. Apple, Disney, Nvidia) represents the bulk of Total Equity or Book Value. The value of any Share Capital that had been issued at its IPO >20 years ago tends to be completely obscured by the cumulative Net Profit after dividends generated by the company over those 20 years. Hence, for argument’s sake, we can say that a company’s Retained Earnings represents most of its Total Equity or Book Value.
Why is this important? In business cash is king — so think about what those Retained Earnings represent in cash terms. As we saw earlier, the Retained Earnings of a company represents all cumulative Net Profits after dividends since the company’s inception. While Net Profits are not strictly cash in nature, they do represent cash profits as long as there isn’t any fraud going on. This is why over the long term, a company’s Cash Conversion Ratio (NP/OCF) should average at around 100%, otherwise it’s a red flag.
Dividends are clearly paid out in cash. When they are paid, those dividend amounts are deducted as a double entry from both Retained Earnings and Cash & Cash Equivalents on the company’s balance sheet (Dr Retained Earnings, Cr C&CE). Hence, when we say that the Retained Earnings of a company represents all its cumulative Net Profits after dividends since the company’s inception, it simply means that Retained Earnings represents all the cumulative cash profits belonging to shareholders that have been reinvested back into the company.
Example: Let’s say a company has a 100% dividend payout ratio, i.e. it pays out all of its annual Net Profits as cash dividends. In that case, its Retained Earnings would persistently be zero (assuming no losses). The average Net Profits of that company over the long-term can also be likened to the interest of a fixed income instrument (e.g. 5% US Treasuries).
In the above scenario, the company pays out all of its annual profits as dividends every year. However, when a company has profitable opportunities to pursue, shareholders might opt instead to plow those “interest payments” back into the business, in pursuit of growth. Those related cash flows would subsequently be used to acquire new assets for the business, which naturally would be expected to increase future Net Profit.
In cash flow terms, this could be likened to if the company had paid out all of its Net Profits as dividends every year — but subsequently took back those cash dividends as share capital, by issuing new shares to the same shareholders in order to reinvest those dividends back into the business. In this scenario, those reinvested profits would be reflected under Share Capital.
However, if it hadn’t paid those dividends and simply held onto the cash instead, those amounts would simply remain in Retained Earnings. However, they would make zero difference to Total Equity/Book Value (or cash flow) as compared to if the company had simply decided not to pay dividends and reinvested those profits back into the business instead.
Hence, the Retained Earnings amounts on a company’s balance sheet represents the share of Asset value contributed by shareholders over the entire life of the company. In other words, they represent the cumulative lifetime investment by shareholders into the company.
If you really think about it, this is also why we call Total Equity = Net Assets. As noted earlier, such cash flows in the business are reinvested into the business’s assets. After netting off liabilities, Net Assets represent the identical cumulative amounts reinvested by shareholders into the company.
ROE = Shareholder yield
Of course, just knowing that the Retained Earnings of a company represents the cumulative lifetime investment by shareholders into the company doesn’t tell us much in isolation. What matters to investors is understanding its role in determining shareholder yield, i.e. ROE.
ROE = Net Profit/Total Equity. Its real-life implications are easy to understand in business terms — it’s simply the annual Net Profits divided by the lifetime cumulative investment by shareholders. Hence, it represents shareholder yield.
Given the context above, we can see how ROE is comparable to the interest yield of a fixed income instrument (e.g. 5% yield of US Treasuries). A company’s LT average ROE should approximate the shareholder yield of the business. Hence, we can directly compare the opportunity cost between the shareholder yield of a business (e.g. 5% ROE) and the interest yield of US Treasuries (e.g. 5% YTM). The investment with the higher yield is more profitable, form notwithstanding.
Earnings Yield = True shareholder yield
Now that we have established that a company’s ROE represents its shareholder yield, we are ready to take the next step towards understanding how a stock purchase represents a direct investment into the underlying business.
At this point, most people can agree that ROE represents shareholder yield at the business level. However, that doesn’t equal shareholder yield at the shareholder level. For example, there are many businesses with triple-digit ROEs (e.g. Apple’s 150% ROE in FY23) — yet it clearly does not reflect the actual shareholder yield for those who acquire Apple’s shares on public markets. What gives?
This expectations gap can be explained by the fact that those shares are being acquired on public markets — rather than a direct investment into the business assets at their legacy values. When you acquire Apple shares on the NASDAQ, you are not paying their Book Value price. Rather, you are usually paying a significant premium to Book Value to acquire their shares, as represented by the Market Cap. This market premium is reflected in the P/B ratio of the company, e.g. Apple’s trailing P/B = 35x.
At the end of the day, it doesn’t really matter what form that investment takes — what actually matters for shareholder yield is the price paid. When you buy Apple’s shares at 35x P/B, you are effectively diluting your ROE by 35x as well. ROE represents shareholder yield, hence if you pay 35x Book Value instead of 1x, your “true ROE” is reduced by 35x. The official term for this “true ROE” is simply the Earnings Yield, which itself is simply the inverse of the PE ratio.
Hence, we can see how the Earnings Yield represents “true” shareholder yield for shareholders that acquire a business’s shares on public markets — in contrast to one who had invested directly into the business all those years ago. But circling back to our original question — how does that stock purchase of Apple shares on public markets equal a direct investment into Apple’s business?
Summary:
1. ROE = Net Profit / Total Equity
2. ROE = Shareholder yield
3. P/B = Market premium
4. ROE / P/B = Earnings Yield (inverse of P/E)
4. Earnings yield = "true" shareholder yieldTying it all together: How a Stock Investment = a Business Investment
Now that we’ve established the aforementioned 3 concepts, we can jump back and forth between them to explain how acquiring Apple’s shares on the NASDAQ represents a direct investment into Apple’s business.
As we’ve noted above, the Retained Earnings of a company represents the cumulative lifetime investment by shareholders into the company. When you acquire Apple’s shares on the NASDAQ at their Market Cap value (e.g. $2.6T), you are simultaneously paying for:
the value of their Net Assets/Total Equity/Book Value;
the market premium as represented by their P/B.
Example: Apple’s latest Book Value is worth $75B, however their Market Cap is worth $2.6T or $2,600B. Hence, when you pay their Market Cap of $2.6T to acquire their shares, you are simultaneously paying for both their Book Value of $75B + market premium of $ 2,525B ($2,600B - $75B) — with the latter “spread" being represented by their 35x P/B.
Why do I segment their Market Cap into two parts this way? It is to make a clear distinction between the amounts which you are investing directly into Apple’s business vs. the amounts which you are not.
Their Book Value of $75B represents your direct investment into Apple’s business, when you acquire their shares on the NASDAQ. This is because when you buy Apple shares on public markets, you are effectively liquidating an existing shareholder’s investment capital and replacing their invested CAPEX amounts into Apple’s business. Hence, this Book Value represents the amounts directly invested into Apple’s business.
However, Apple’s Market Cap of $2.6T that you are paying to acquire their shares on the NASDAQ also includes a substantial $2,525B worth of “non-Book Value” amounts. As we’ve noted earlier, these amounts are reflected in their P/B ratio. These market premium “spread” amounts are not direct investments into Apple’s business. Rather, they represent the market premium that you are paying to participate in Apple’s future profits. This market premium/discount exists since these future profits involve uncertainty — in contrast to historical ROE which has zero risk, and therefore is priced efficiently.
In essence, if you are willing to buy Apple’s shares at 35x BV, it simply means that you are willing to accept 34x less in shareholder’s yield than the actual business yield (e.g. 150% ROE / 35x BV = 4.3% Earnings Yield). For instance, this could be because you think that their current Earnings Yield can continue growing in the future to justify that P/B market premium.
This is why we say that a company’s fair value (e.g. NPV) is represented by its future discounted cash flows or future earnings. Few will disagree that a company can command fair value relative to its current shareholder yield or ROE. However, it is the business’s future discounted cash flows, which embody future uncertainty, that commands a much more subjective market premium to Book Value. Nonetheless, it doesn’t take away from how “true” shareholder yield can be represented by Earnings Yield.
Summary:
1. Market Cap = Book Value + Market Premium (P/Bx)
2. Book Value = Amounts invested directly into the business
3. Market Premium (P/Bx) = Amounts representing future uncertainty; are not invested directly into business
4. NP/Market Cap = Earnings yield = "true" shareholder yieldValue Investing = Picking Stocks Like Billionaires
With these concepts in place, we are finally ready to tackle the topic of determining shareholder yield from a value investor’s perspective.
As widely recognized, value investing proclaims to be about investing directly into the underlying business, rather than simply trading paper profits. So how do we as value investors determine whether we are getting an adequate shareholder yield from our investee businesses — e.g. 15% CAGR over 5 years?
The common approach to thinking in terms of shareholder yield is capital appreciation, i.e. the upward movement of stock prices. Having said that, as value investors we are more concerned with business yields. So how do we square between capital appreciation and business yields with respect to measuring shareholder yields from a value investor’s perspective?
Consider how a businessman thinks about shareholder yields — they’d typically just think of it as ROIC, or payback period. If I invest $100 into a business and get an annual profit of $15, then I generate a 15% return (payback period of 6.6 years). However, I may also be willing to entertain a lower return in year 1 (e.g. 5%) if I think those profits can grow in the future, to eventually equal a LT average return of 15%.
Importantly, we are describing 15% CAGR from the perspective of the initial investment capital — not the earnings growth of the business. The focus here remains shareholder yield, not profit growth per se. Earnings growth is simply one function of the calculation of shareholder yield. Hence, value investors interpret 15% CAGR returns from the same perspective as businessmen — which is entirely logical, since value investors actually do think of themselves as business owners.
This is irrefutable proof that Value Investors = Business Owners.
As we’ve expounded on above, value investors interpret shareholder yield as Earnings Yield. Therefore, when a value investor says that they’re aiming to earn 15% CAGR over 5 years, they do not necessarily mean it in the context of share price capital appreciation — which can be a matter of share price volatility. Rather, value investors genuinely intend to earn 15% CAGR as a matter of Earnings Yield from the underlying business profits — similar to how a businessman thinks about shareholder yield. The corollary is that value investors truly treat their investment capital as “investments”, rather than simply “renting” shares for a quick flip.
This example is easier to illustrate if you think about stock investments from the perspective of a billionaire. As a billionaire, it can be difficult to find sufficiently large private businesses to invest in which can absorb all of your available capital — hence, it makes sense to look for business returns in public markets. If a billionaire feels that getting 5% returns from investing in US Treasuries isn’t adequate, he might be willing to invest in a listed company with higher risk for 15% returns. In this case, he’d be treating his stock purchase as a business investment — in the same way that value investors would.
What 15% CAGR over 5 Years really means
This also explains why value investors tend to gravitate towards relatively cheaper multiples. Whether in value investing, private equity or vanilla business M&A, by far the largest lever determining your investment yield is the acquisition price. A low acquisition price can offset lower business earnings growth for years; whereas a high acquisition price can likewise offset higher earnings growth for years. And since there is typically a direct relationship between growth and price, you can see how it is not one or the other which matters more, but rather the relationship between growth and price (alá growth:price ratio).
In private markets, this growth:price ratio is usually quite efficient, and therefore the chances of mispricings occurring is quite minimal. Luckily for value investors, Mr. Market tends to offer mispriced opportunities on a relatively regular basis. This is not to say that such opportunities are immediately obvious to everyone — those get arbitraged away quickly — but anyone with a keen eye and deep analytical ability can testify to how surprisingly regularly they appear in public markets.
Of course, this is not to say that capital appreciation doesn’t matter in stock markets — after all, what more objective way is there to measure performance than by observing market prices? Fortunately, efficient markets tend to accurately arbitrage a business’s Earnings Yield by raising its share price in public markets. Hence, a 15% Earnings CAGR at the business level tends to also be reflected as a like increase in its LT share price, ex-volatility. Over the course of a full market cycle (e.g. 5 years), there are usually ample opportunities for efficient markets to reflect improving business performance via a like capital appreciation in its share price.
However, it remains crucial to observe the distinction between 15% CAGR from capital appreciation, and 15% CAGR from an Earnings Yield perspective. The latter is almost always part of the former, but the former is not necessarily the latter (due to volatility) — just like how a chicken is always a bird, but a bird is not necessarily a chicken. While public accountability over performance will always be important, at the end of the day value investors interpret shareholder yield as a matter of Earnings Yield, not capital appreciation per se.
Hence, the value investor’s interpretation of “15% CAGR over 5 Years” simply means to look for businesses which can deliver enough earnings growth relative to their acquisition price to generate an effective shareholder yield of 15% over a full market cycle. Crucially, this focus on yield rather than price activity means that it is not just underlying business growth that matters — the acquisition price matters too.
Check out our previous Value Investing articles:
Ultimately, the most effective way I’ve found to discover such 15% CAGR returns as value investors is by looking for mispricings. If you’re interested in learning more, I’ve previously written detailed articles discussing mispricings from a value investing perspective — click the links of the value investing articles below if you’d like to find out more!
Nicely done, Aaron. I've owned small businesses for 25+ years now, and it was only upon reading Buffett's letters that I really began to understand small business ownership at a higher level.
Similarly, the small business owner has something of a value-investing edge if they can pick up the fundamental concepts you outline here and start thinking of their own businesses as a slice of ownership (in my case, I own fractional shares anyway, so this part is easy). Applying the same logic that has kept a small business alive - not irrationally spending on things that won't make you any money, EG, helps when considering stock investments.
The ROE and retained earnings stuff was explained particularly well.
How about difference between ROE and ROC in terms of owners earnings ?