Earning Yields and the Price-to-Earning Ratio of Blue Chip Stocks

A Real World Example of Applied Value Investing

Blue Chip Stocks and Earnings Yield
In the long-run, the only thing that matters for your blue chip stocks are the earnings per share, the valuation multiple that is applied to those earnings, and the total dividends that are distributed to you for spending, saving, reinvestment, or giving. Steve Allen / Getty Images

Allow me to share with you an investing parable. Here's the story.

The Background

Imagine that you own a business earning $100 million. Things are going well and you bring in a new CEO. Let's call him Bob. At the time of his hire, Wall Street is insanely enthusiastic about the future and values your company at $4.2 billion market capitalization. It's a ridiculously stupid number that is completely detached from what any reasonable buyer would pay.

In fact, any man or woman who would buy a stake in the business at that price is foolish.

Increasing Company Profits

Six years later, that CEO has worked wonders. Bob has turned your $100 million in annual profit into $250 million in annual profit. He's boosted dividends. He's bought back so much stock that the earnings per share growth actually exceeds the overall company's profit growth, meaning higher returns for long-term owners. He's diversified operations. Generally speaking, he's done a fantastic job. You are so thrilled that you decide to pay him less than 1% of the company's earnings, or $2.5 million. Sure, it is a lot of money, but in light of the fantastic performance, every penny is deserved and it still leaves 99% of the company's profits for the owners, who are now enjoying a much larger earnings base, a much bigger company, and even better returns on equity.

Company Profits vs. US Treasury Bond Yield

Over the six years that Bob was working his magic, the folks on Wall Street started behaving rationally.

They looked at the yield on the United States Treasury bond, which was around 6.5%, compared it to the profits the company was earning, and after six years, are now only willing to pay $3.5 billion for the company.  

In other words, six years ago, for every $1 in profit your business generated, they were willing to pay $47 to own a piece of the firm.

Today, they are only willing to pay $14 for that same $1 in profit. Even though your total profits increased by 2.5 times, the actual value of the company on a quoted basis fell due to the valuation drop. (To re-phrase, that means a handful of speculators drove up the price and offered $4.2 billion for the business when it was making $100 million on the day you hired your new CEO, Bob, but now that it is making $250 million, they are only willing to pay $3.5 billion.)

Of course, Bob has nothing to do with this. He's done a great job. The first figure, $4.2 billion for $100 million in profit, is almost criminally idiotic.The second figure, $3.5 billion for $250 million in profit, is much more reasonable. He can't control any of that. All he can do is try to increase sales, close underperforming stores, roll out new locations, make customers happier, lower costs, increase margins, and boost returns on capital.  

The Fallout

Upset at Bob when they should have been upset at their own financial negligence, the investors who paid $47 for every $1 in profit the company generated storm the shareholder meeting, demand that Bob not be paid his $2.5 million. "We've lost money over the past six years!" they scream, full of righteous indignation.

The Board of Directors, being rational businessmen and women, know how unjustifiable this anger is. They can't control the fact that six years ago, a handful of owners were willing to overpay for their share of the company. Nor can they control that rationality has finally returned to the markets and new shareholders today are actually paying sane prices that have a good probability of turning out well in the end. 

The village idiots continue their outcry and ultimately create such an unpleasant situation, that Bob resigns.  

The Story of Home Depot Stock 

The story above isn't actually a parable; it really happened. I wrote an article about the then-shareholder revolt at The Home Depot. It was 2006. The economy was booming, the housing market reaching an all-time peak, and Home Depot's profit margins, net income, and per-share earnings were climbing ever higher.

At the same time, the stock price continued to sink lower.  

To explain the reason, I illustrated the math that during the dot-com boom, Home Depot stock had reached an absolutely absurd valuation of 47x earnings. That resulted in an earnings yield of 2.13% at a time when the 30-year Treasury bond was yielding more than 6.5%.  

In simpler terms, you could have either invested your money in a 30-year United States Treasury bond and generated a guaranteed 6.5% on your money, or you could have invested in Home Depot stock, generating 2.13% on your money plus the potential for future growth. With Home Depot ranking as the world's largest home improvement retailer at the time, and the domestic market saturated, high future growth seemed completely implausible, if not impossible.

Why the Shareholders Were Wrong 

Still, this was not the fault of the CEO, Robert Nardelli, who had taken over the post after losing out the top spot at General Electric to Jeff Immelt. He had come into the job in 2001 and for six years, revolutionized the bottom line returns using the same methods employed at GE. As I said back then, "Consider that when Home Depot traded around $70 per share at the height of the stock market bubble, the retailer was earning around $2.6 billion and had approximately 2.3 billion shares outstanding. For fiscal year ended 2006, the company is expected to report a net profit in excess of $6.5 billion and have only 2.1 billion shares outstanding. In essence, as an owner of Home Depot, not only has your company increased earnings 250% during Nardelli’s tenure, but 10% of the outstanding stock has been repurchased and retired, increasing your equity in the business proportionately.

In addition, in the past six years sales have grown from $45.7 billion to $92.5 billion, the number of stores has increased from 1,134 to 2,160, the net profit margin has gone from 5.6 percent to 7.0 percent, return on shareholder equity from 17.2 percent to 21.5 percent, the dividend has increased more than 275 percent, and it has acquired a number of general supply businesses such as National Water Works, the company that provides fire hydrants and water pipes to municipalities throughout the United States, thus diversifying the company’s operations.

What the Math Says

The math was crystal clear. While profits per share had grown considerably, the multiple that investors were willing to pay for each $1 in earnings fell from a completely unjustifiable 47x earnings to a much more reasonable 14x earnings. This caused the stock price to decline despite a great performance. However, it created a situation where the stock began to look reasonably attractive. At that valuation, your earnings yield was 7.14% compared to the yield on 30-year Treasury bonds at the time, which was 5.16%. The earnings yield on the S&P 500 during this same period was a little more than 6%.  

If growth rates and valuation multiples held constant, the same math you learned in 4th grade tells you that you should generate a better return from Home Depot than you did from the S&P 500, even if it took years. To paraphrase Benjamin Graham, in the short-term, the market is a voting booth that tracks popularity, greed, and fear, in the long-run, a scale that weighs value, which comes down to earnings per share relative to the price you pay compared to the opportunity cost of investing in safe bonds.  That is the formula. That is what you are doing when you build a portfolio. The question you, as an investor, needed to answer is whether or not you thought the growth rate of the S&P 500 would exceed that of the per share earnings of Home Depot.

The Backlash

When I explained the earnings yield math, there was quite a backlash. Email messages, comments, and even other bloggers writing about how I must have lost my mind to consider the performance pay reasonable. The arguments essentially came down to, "I don't care what the business does, all I care about is the stock price." If that is your philosophy, you are going to have a hard time making money.

I still believe it was insulting and inappropriate, especially in light of real performance excesses like what happened at Tyco, to compare Robert Nardelli's well-deserved pay package excessive when the people who were complaining almost universally had no one but themselves to blame. As a then-owner of the business, I was perfectly happy to collect my cash dividends, watch shares outstanding fall each year, see dividend payouts increase, watch returns on equity grow, and still know that total executive compensation was less than 1% the company's annual profits. After all, in their younger days, great executives like Warren Buffett were taking 25% of the businesses that they ran (e.g., Buffett Partners), private equity managers were taking 2% of assets and 20% of profits of their funds. A single percentage point was well deserved.

Shareholders in Home Depot Have Done Very Well Despite the Real Estate Collapse 

The bigger lesson here is about valuation. If you need proof that valuation and earnings matter, consider that you would have done very well by investing in Home Depot stock when this mess was going on relative than what you would have earned buying into the S&P 500 despite living through the worst economic collapse since the Great Depression, and the most violent real estate bubble burst since the 1870's.  

Scenario 1: You Invest in Home Depot: It is May 26th, 2006. You have $100,000.  You decide to invest in Home Depot.  The stock closed at $38.67. You got 2,585.98 shares. Today, the stock trades at $51.97, bringing your total position to $134,393.59. That is a capital gain profit of $34,393.59.  You also collected $5,499 in cash dividends along the way, bringing your total return to $39,892.59.  That works out to almost exactly 7% compounded.  

Scenario 2: You Invest in the S&P 500: It is May 26th, 2006. You have $100,000. You decide to invest in the S&P 500 by buying a low-cost index fund. The Vanguard 500 fund closed at $118.21 that day. You bought 845.95 shares. Today, it trades at $129.45 per share, bringing your position to $109,508.50. That is a capital gain of $9,508.50. You also collected $13,497 in cash dividends along the way. Your total return is $23,005.50. That works out to roughly 3.5% compounded.

Scenario 3: You Invest in the 30-Year Treasury: It is May 26th, 2006. You have $100,000. You buy a 30-year Treasury bond. You collect 5.16% interest each year. You'd have already collected $30,960 in cash interest income, you'd have a decent capital gain on your bond because interest rates have fallen, and you'd still have 24 years remaining to keep those checks rolling into your proverbial mailbox.  

The Bottom Line

What happened with Home Depot was, is, and will always be the same thing that moves all asset prices in the long-term: The relative earnings yield compared to the Treasury bond yield or another appropriate risk-free benchmark. People may lose their minds in the short-term but in the long-run, what counts is how much cold, hard cash you can take out of a business to give away, spend, save, or reinvest.  That is the only metric that drives valuation.