The only equation the share investor will ever need 3 comments
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In terms of quantitative stuff, the only equation that the share investor needs to understand is the following, known as the dividend discounting model:
Value of stock is equivalent to price; dividend is usually calculated as the most recent dividend; discount rate is the cost of equity (usually related to interest rate + a risk premium for shares ---> the riskier they are, the higher the premium); dividend growth rate is directly related to earnings growth assuming the company adopts a steady dividend payout policy as a function of earnings.
The idea is based on the fact that the value of a stock is basically the sum of all cashflows (all the way to the distant future), via dividends, to the investor. The further into the future a certain cashflow, the more it must be discounted by the interest rate, to get its present value.
Although the quantitative model is simple enough, it is often easy to forget its qualitative implications. I find it useful to remind myself of the DDM implications once in a while:
(1)The importance of dividends - The value of a share is all about the actual cashflow to the investor, typified by the flow of dividends and their growth. There are differing schools of thought on dividends, with some arguing that if the return potential of corporate growth opportunities exceed that of the individual investor's, profit should be withheld. Yet if the individual investor has doubts in his reinvestment capabilities, he should not be practising active investing in the first place. That two terms in the DDM: the numerator and the dividend growth rate term in the denominator, are related to dividends, surely mean something. As Cuba Gooding Jr. says in Jerry Maguire: "Show me the money!". For further reading, refer to my article on "The attraction of dividends".
(2)The importance of shareholder orientation - The value of a stock lies in the tangible benefits it brings to the investor, in the form of cashflow, rather than reported profits, which is just a figure on paper. It is worth noting how many steps there are from corporate profit trickling down as cash benefit to the investor. First the profit has to be collected from debtors/customers ie. receivables need to be converted to cash. Then management has to decide on cash allocation for investments, working capital, debt repayment etc, to maintain operations integrity. Finally, the residual is available for distribution to shareholders. And management might just want to keep all this cash to themselves! Why so? Perhaps they want to make acquisitions to expand the scale of operations, sometimes for intentions less than noble. Or their parent company may not be in favour of generous dividend payouts, maybe because they want to keep cash assets within the overall group to make balance sheets look good (especially when financial figures are consolidated), or for other reasons (eg. for Isetan, it was for tax considerations). Whatever it is, the chain is only as strong as its weakest link, and if shareholder orientation is weak, profits might not translate to dividends for shareholders at all (those interested can examine the case of Swing Media).
(3)An appreciation for risk - Consider the denominator term. It is the difference between discount rate and corporate growth rate. This means a small change in either means a lot to the stock valuation. Let's focus on the discount rate, which is linked to both the base interest rate and a superimposed equity risk premium (due to the investing risk people perceive of shares). A rise in either raises the discount rate and profoundly affects the "fair price" of the stock adversely. Thus the "fundamentals" of a stock can relate to more than just the business of the company per se --- if one considers valuation of the stock as part of its "fundamentals" (has to be, right?), then a rise in interest rate, or a rise in investor risk aversion towards risky assets ...... all this leads to a decline in fair value. Suppose, for example, that due to increased debtor risk, the banks decide to raise interest rates to factor in increased default risk. At the same time, investors around the world decide that they will be more risk-averse in case a liquidity crunch arises. Sounds familiar, right? The DDM equation, in fact, implicitly takes into account the effects of liquidity as well as investor sentiment/perception within its fold.
Lastly, I have never believed that it is possible to calculate the fair value of a stock based on the DDM equation stated above. Rather, indeed, it is often used instead to reverse-calculate the equity risk premium incorporated into market prices. But the equation itself holds tremendous value in allowing us to understand the qualitative aspects of what lies behind the fair value of a stock. Internalise it and its principles can be applied to many other investment instruments.