To continue with the example, I presumed that 80% of total profits would be utilized for share repurchases and dividends. Using the 2% company-wide growth rate assumption, that worked out to an average of roughly $240 million a year going toward share repurchases. Just to give you some context, over the past five years the company has averaged closer to $1.2 billion annually going toward repurchases, so once again I don’t think that this is an especially far leap.
Yet even in this scenario, depending on the average price paid, Kohl’s could retire perhaps 40 or 50 million shares over the next decade. This would mean that the share count could decrease by just under 3% annually, moving from around 195 million down to perhaps 145 million.
Valuation
Valuation can be a tricky thing – naturally we don’t know the price that other people may or may not be willing to pay for shares 10 years down the line. And as illustrated above, even if your underlying earnings claim is increasing, this doesn’t mean that the share price has to as well. (To be sure the chances are better when this happens, but there’s nothing stopping a security from going from 20 times earnings down to 12.)
Over the past decade shares of Kohl’s have traded with an average earnings multiple of about 13. It’s certainly possible that shares follow a similar path as they had in the past and go down to say 7 times earnings in the future. However, I think it’s important to remain cognizant of the idea that this would simultaneously imply a future dividend yield of around 7%. Let’s stick near the historical average (actually just below) and use 12 times earnings.
Putting it All Together
Now we’re ready to put it all together. There have been hints as we’ve gone along, but the actual value of these assumptions has not been revealed. If Kohl’s were to make $900 million in profits 10 years from now and have 145 million shares outstanding, you’d anticipate an earnings-per-share number of about $6.20. At 12 times earnings, that equates to a future price of roughly $75. If we add in the cumulative dividends of $27 per share that comes to a total expected value of about $102. On an annualized basis, based on a share price around $43, that equates to a total annualized gain of about 9%.
Although it doesn’t perfectly match up to the description above, here’s a basic construct of what that might look like (keeping in mind that this is merely a baseline and ought to be adjusted according to one’s own expectations):
I won’t go through the whole table, but I would like to make a couple of points.
The middle column is presented for reference, showing the history of Kohl’s as detailed above. The right-hand column presents a hypothetical scenario based on the assumptions that we worked through.
First note that the earnings-per-share growth is actually lower than what was achieved in the past decade. Yet the Kohl’s security of today has a couple of things working for it that were not present with the Kohl’s of 2005.
First, you have a valuation closer to 11 times earnings instead of 20. This allows for a much greater likelihood of the share price performance matching (or besting) the business performance. The possibility of P/E compression is still present, but I would contend less likely.
Furthermore, you now have a dividend yield sitting around 4.7%. You don’t need much (or any) payout growth in order for the dividend to contribute meaningfully to the bottom line.
Combined, these two factors could very well be the difference between the lackluster past and potentially solid future. It’s not that the business is that much better or worse, it’s just that the valuation gives you a healthy starting yield and a better chance at capturing business performance.
I find the 9% annualized return assumption interesting for a couple of reasons. First, that represents a solid return. As a point of reference, that’s the sort of thing that could turn a $10,000 starting investment into $24,000 after a decade. If you could achieve a 9% average compound return for an investing lifetime, you’ll be in the driver’s seat as far as long-term wealth creation goes.
Beyond that aspect, I don’t think that my assumptions are that large of a stretch. You have analysts anticipating 6% to 9% growth. In comparison, I talked about 2% business growth, using way less funds for share repurchases, thinking about an earnings multiple under 13 and a company paying out around half of its earnings in the form of dividends. Those assumptions aren’t exactly shooting for the moon, and yet the results could still be quite solid.
Final Thoughts
Naturally if the company starts to decline the results could be much worse, but it works the other way as well.
If shares of Kohl’s Corporation (NYSE:KSS) later trade at say 15 times earnings or the company grows by 6%, suddenly you have the opportunity for a “bonanza” of a return in relation to today’s valuation proposition.
In short, if you’re only looking to partner with the very best firms then Kohl’s will probably not be on your list.
And to be frank, this is a perfectly legitimate stance to take – your capital is limited so you want to make sure that you’re comfortable with all of your partnership decisions. Yet if you would like to partner with, or at least learn more about, a “second tier” type of investment I think something like Kohl’s fits that bill.
In doing so you want to make sure that you’re compensated in the way of a compelling valuation. If things go well, you don’t just want to see returns on par with your typical high-quality mega-firms. If you’re going to be taking on additional risk in the way of looking beyond the Johnson & Johnson’s of the world, the return proposition ought to be more compelling. For Kohl’s I think that fits – if things go marginally you could do well, but if things go better than expected you could very well expect great things.
Disclosure: This article is originally published in Sure Dividend by Eli Inkrot.
