After paying dividends and funding core growth, a company may have cash left over. It could opt to pay down debt, which would reduce interest expense and thus increase earnings. It might make an acquisition or some other investment, though the returns here could be spotty. Finally, it might opt to buy back stock.
Whatever the company decides to do with these excess funds, we put the result into the growth bucket of our prospective total return. In other words, we assume that any cash not used for a dividend is employed to create earnings and dividend growth. To get a proxy for the added growth potential of remaining earnings, we'll make an additional assumption that the path of least resistance is a share buyback.
This assumption is meant to err on the side of conservatism. The earnings yield (the inverse of P/E) on most stocks is generally much less than a company's return on equity, so we're not projecting much bang for this last slice of our buck. And acquisitions--returns of cash to someone else's shareholders--tend not to be priced for returns equal to existing investments.
Share buybacks boost earnings growth--EPS grows not only when the numerator (profit) expands, but also when the denominator (shares outstanding) shrinks. Dividing the excess earnings into the stock price gives us an "excess earnings yield," the third component of our total return calculation. So if Coke uses the last $0.56 of per-share earnings to repurchase stock, it will be able to retire 1.2% of its shares in the first year ($0.56 divided by a $45 share price). That, in turn, gives next year's earnings per share a 1.2% tailwind--even if earnings are flat, fewer shares outstanding mean higher earnings per share.
So What's It Worth? >>