The Total Shareholder Return (TSR)

The Total Shareholder Return (TSR)

Author: Joris Kersten, MSc

Kersten Corporate Finance: M&A Advisory + Valuations @ The Netherlands. www.kerstencf.nl

Training: Business Valuation & Deal Structuring, 5 day training, yearly, next one: 4 – 8 November 2024 @ Amsterdam South (Zuidas). www.joriskersten.nl

Source used: Morgan Stanley Investment Management, Counterpoint Global Insights. Total Shareholder Return: Linking the drivers of total returns to fundamentals. October 2023. Michael J. Mauboussin & Dan Callahan.

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Introduction

Expectations about a company’s future “free cash flow” should determine the value of its stock.

You can see the “total shareholder return” (TSR) over a period, as the change in the stock price + any cash the company paid to its equity holders.

TSR is the “capital accumulation” rate that investors earn when they reinvest all of their dividends into more shares.

So TSR = price appreciation of the stock + ( 1 + price appreciation ) * dividend yield

So TSR is divided over:

·???????? Price appreciation,

·???????? Dividend, and the,

·???????? Dividend reinvestment.

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Price appreciation is again divided over:

·???????? Earnings per share growth, and the,

·???????? P/E multiple change.

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And earnings per share growth is again divided over:

·???????? Net income growth, and the,

·???????? Change in net shares outstanding.

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TSR for the S&P 500

The S&P 500 is an index that tracks the results of the shares of the 500 largest companies listed in the US.

For the period 2011 – 2021 the annual TSR was 16.6 % (see source I have used for this blog).

The following drivers contributed to the return:

·???????? Net income growth: 6.7% + Reduction in shares outstanding: 0.7% = EPS growth of 7.4%.

·???????? P/E multiples expansion: 6.9 %.

·???????? Price appreciation = 7.4 % EPS growth + 6.9 % P/E multiple expansion = 14.3 %.

·???????? The divided yield averaged 2 % and the dividend reinvestment 0.3 % ( 0.143 * 0.02 ).

·???????? 14.3 % price appreciation + 2.3 % from dividend & dividend reinvestment = 16.6 % TSR.

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So the contribution of each driver for the TSR is roughly:

·???????? Earnings per share growth: 44 %;

·???????? Multiple expansion: 42 %;

·???????? Dividends & dividend reinvestment: 14 %.

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Net income growth

Net income equals the EBIT (earning before interest and taxes) minus net interest and corporate tax.

A company’s cost structure determines the “operating profit margin”.

This is “operating profit” divided by “sales” (revenue).

The aggregate operating profit margin for companies in the S&P 500 is on average 14% during 2012 – 2022. (again, please see source I have used for this blog)

Here “operating leverage” is important.

Operating leverage is the “change in operating profit” as a function of “sales”.

Companies with “high fixed cost structures” have a good “operating leverage”.

This because the fixed costs are now divided over more sales, and this is a "leverage effect" in the operations.

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The cost of debt

Interest shows up in the income statement.

Let’s now take a look at the cost of debt for “BBB US corporate bonds” from 2008 – 2022.

BBB is the lowest rating that still qualifies as “investment grade”.

The cost of debt (or expected return) starts with the yield on the 10-year US treasury note.

And then adds “inflation expectations” and the “credit spread”.

The credit spread is the return bondholders demand over the treasury note to compensate for the risk.

S&P Global, one of the leading credit rating agencies, rates bonds globally.

About 75 % of the bonds are “investment grade” and “rating BBB” is the most common rating.

During 2012 – 2022 interest rates/ corporate bonds yields went down for the S&P 500.

In addition, many companies held cash, which resulted in interest income.

Moreover, the "debt to total capital ratio" went down.

So the “pre tax margin” (EBIT after net interest, but before taxes) went up for the aggregate of companies in the S&P 500 over the decade 2012 – 2022.

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Corporate Taxes

From pre tax income the taxes are subtracted to get to net income.

Net income margins also increased due to a decreasing tax rate.

The decline in interest costs, and taxes, realised that companies in the S&P 500 grew their net income at a rate of 6.7 %.

But this in a time where their EBIT ( operating profit ) grew with only 5.6 %.

Interest, and tax, expenses went down from roughly 32% to 24% of EBIT.

This phenomenon is there since 1980 already, which has allowed “net income” to grow faster than “EBIT” over time.

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Shares outstanding

Earnings per share is net income divided by shares outstanding.

Companies issue shares for:

·???????? Mergers & Acquisitions ( M&As ) financed with equity;

·???????? Stock based compensation ( SBC );

·???????? Equity offerings.

And companies retire shares through buybacks.

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Since 2000 public companies in the US have issued less equity than they have retired.

From 2006 to 2022 equity financed M&A deals were the largest component of equity issuance.

This followed by SBC.

Then followed by “seasoned equity issuance” (SEOs), and this is just new shares that are issued.

This for example for CAPEX or R&D.

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M&A and EPS

An M&A deal always adds to the buyer’s EPS when its P/E is higher than that of the seller (target).

This is called “EPS accretion” !

So here the EPS rises, even when there are no financial benefits of putting the companies together !

Conversely, EPS always fall when the buyer’s P/E is lower than that of the seller (target), in an all equity financed deal.

This because “you buy the earnings at a higher price”, so with an all equity deal, you dilute !

But actually investors should NOT look at EPS accretion/ dilution, but instead focus on the real “economic characteristics” of a deal.

The simplest (good) way to look at the value creation potential of an M&A deal is:

·???????? Estimating the present value of the synergies -/- the premium paid.

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SBC (stock based compensation) & secondary offerings

SBC has risen from 0.2 % of sales in 2006 to 1.3 % of sales in 2022.

The percentage tends to be higher for smaller, and young companies, than for larger, and older companies.

M&A deals financed with equity, SBC, and seasoned equity offerings, all increase shares, and can cause “EPS dilution”.

Share buybacks are a way to return capital to shareholders, and to reduce the number of shares.

But unlike dividends, which treat all shareholders equally, buybacks that occur at “any price other than the fair value”, result in a “wealth transfer”.

The decision to retire stock through buybacks, and issue stock through SBC, are often linked to each other.

This means that executives buy back shares to offset the dilution from SBC programs.

Overall, the shares outstanding for the participants of the S&P 500 shrank.

And this reaction contributed for 0.7 % to the TSR of 16.6 % during 2011 – 2021.

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Value creation & EPS accretion/ dilution

Understanding equity issuance, or retirement of equity, can provide insights into the relation between “net income” and “EPS growth”.

Technically, executives should invest only in opportunities where the "present value of the future cash flows" is expected to be higher than the cost.

So executives should maximise this “net present value”.

However, in practise many executives focus on maximising EPS.

This also in relation to buying back stock, so they buy back stock in order to increase EPS.

But there is no evidence that increasing EPS through buybacks creates shareholder value !

On the other hand, the presumption that buybacks always increase EPS is wrong !

This because companies need to fund buybacks with debt or excess cash. So interest income will disappear, or new interest will appear.

Moreover, buybacks are also a function of the earnings yield ( earnings / price ).

When the earnings yield is higher than the (after tax rate) of interest, buybacks increase EPS.

So when the cost of debt is low, companies are more likely to issue debt for buybacks. Since then they increase EPS likely.

P/E multiple change

You can think of the value of a business as having two parts:

1.????? A steady state value, and,

2.????? The present value of growth opportunities (PVGO).

The steady state value assumes that a company can sustain it current earnings over time.

And the PVGO reflects whether future investments can earn a positive spread between ROIC (return on invested capital) and the WACC (weighted average cost of capital).

This since companies create value when ROIC > WACC.

As a rough estimate, about 2/3 of the stock market’s price (S&P 500 from 1963 – 2023) is attributable to the steady state value.

And estimated about 1/3 is attributable to the PVGO. ( Please see the source I have used for this blog )

The steady state P/E for the S&P 500 (1963 – 2023) fluctuated around 5.1 and 17.7 times.

And on average this is estimated 2/3 of the value, since estimated 1/3 comes from the PVGO.

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This blog discussed TSR and its components:

·???????? Price appreciation, Dividend, Dividend reinvestment, Earnings per share growth, P/E multiple change, Net income growth and Change in net shares outstanding.

I hope this blog gave you a better understanding of the concept TSR (total shareholder return).

See you next week again with a new blog !

Best Joris

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Source used: Morgan Stanley Investment Management, Counterpoint Global Insights. Total Shareholder Return: Linking the drivers of total returns to fundamentals. October 2023. Michael J. Mauboussin & Dan Callahan.