Stock Valuation

Expected Dividends, No Growth

The Dividend Decision

Whether to issue dividends and in what amount is mainly calculated based on the company's unappropriated profit and its earning prospects for the coming year. The amount is also often calculated based on expected free cash flows, which means cash remaining after all business expenses and capital investment needs have been met.

If there are no favorable investment opportunities–projects where returns exceed the hurdle rate–finance theory suggests that management will return excess cash to shareholders as dividends. However, there are exceptions. For example, shareholders of a "growth stock" expect that the company will, almost by definition, retain earnings to fund growth internally.

At the other end of the spectrum, investors of a "no growth" or value stock will expect the firm to retain little cash for investment and to distribute a comparatively greater proportion to investors as a dividend.

Clientele Effects

This suggests that a particular pattern of dividend payments may suit one type of stockholder more than another; this is sometimes called the "clientele effect." A retiree may prefer to invest in a firm with a consistently high dividend yield. In contrast, a person with a high income from employment may prefer to avoid dividends due to their high marginal tax rate on income.

Suppose clientele exists for particular patterns of dividend payments. In that case, a firm may be able to maximize its stock price and minimize its cost of capital by catering to a particular clientele. This model may help to explain the relatively consistent dividend policies followed by most listed companies.

Value Investors

If there is no growth, high-dividend stocks may appeal to value investors. Value investing involves buying securities with shares that appear underpriced by some fundamental analysis. For example, such securities may be stock in public companies with high dividend yields, low price-to-earning multiples, or low price-to-book ratios. Thus, high dividends and low reinvestment of retained earnings can signal an appealing value stock to an investor.

Investing trade-offs: Value investors trade growth for dividends.

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Expected Dividends and Constant Growth

Relationship Between Dividend Payments and the Growth Rate

Ideally, the portion of earnings not paid to investors is left for investment to provide for future earnings growth.

From an investor's point of view, the fundamentals of a company are of the utmost importance. One such fundamental factor that investors consider is how much capital is distributed to investors and, conversely, how much capital is kept from investors. Capital is distributed to investors via dividend payments and indirectly through capital gains. Capital that is kept from investors is known as retained earnings. Investors hope that firms will use retained earnings to either maximize their current operations or invest in such a way as to lead to higher profits. In other words, the portion of profits not paid out to investors via dividends is, ideally, left for investment to provide for future earnings growth.

Some companies require large amounts of new capital just to continue operations. Such firms usually cannot distribute earnings since their funds are tied up in maintenance, repairs, etc. These companies also provide limited growth opportunities since earnings are not reinvested for the purpose of growth. On the other hand, some companies can retain earnings and put that money back to work – i.e., invest in growth opportunities. Firms that can do this tend to retain more of their earnings. These firms are attractive to investors, even though there is relatively low distribution of profits.

Put succinctly, investors seeking high current income and limited capital growth prefer companies with a high dividend payout ratio. However, investors seeking higher capital growth may prefer a lower payout ratio because capital gains are taxed at a lower rate. High-growth firms in early life generally have low or zero payout ratios to reinvest as much of their earnings as possible. As they mature, they tend to return more of the earnings back to investors. Note that the dividend payout ratio is calculated as dividend per share divided by earnings per share.

Understanding Future Stock Value

There are many different ways to appraise the future value of stocks, including fundamental criteria and stock valuation methods.

In financial markets, stock valuation involves calculating the theoretical values of companies and their stocks. The main use of stock valuation is to predict future market prices and profit from price changes. Stocks judged as undervalued (for their theoretical value) are bought. In contrast, stocks that are perceived to be overvalued are sold, with the expectation that undervalued stocks will, on the whole, rise while overvalued stocks will, on the whole, fall.

Stock Valuation Stock valuation involves many methods.

Fundamental Criteria (Fair Value)

The soundest stock valuation method, the discounted cash flow (DCF) method of income valuation, involves discounting the profits (dividends, earnings, or cash flows) the stock will bring to stockholders in the foreseeable future and calculating a final value on disposal. The discounted rate normally includes a risk premium, which is often based on the capital asset pricing model.

Stock Valuation Methods

There are many different ways to value stocks. The key is considering each approach while formulating an overall stock opinion. If a company's valuation is lower or higher than similar stocks, the next step is determining the reasons for the discrepancy.

1. Earnings Per Share (EPS)

EPS is the company's total net income divided by the number of shares outstanding. Numbers are usually reported as a GAAP EPS number (which means it is computed using mutually agreed-upon accounting rules) and a Pro Forma EPS figure (income is adjusted to exclude any one-time items as well as some non-cash items like amortization of goodwill or stock option expenses).

2. Price to Earnings (P/E)

Once one has several EPS figures (historical and forecasts), the most common valuation technique used by analysts is the price-to-earnings ratio, or P/E. To compute this figure, the stock price is divided by the annual EPS figure.

3. Price Earnings to Growth (PEG) Ratio

This valuation technique has become more popular over the past decade or so. It is better than just looking at a P/E because it takes three factors into account: the price, earnings, and earnings growth rates. To compute the PEG ratio, divide the Forward P/E by the expected earnings growth rate (historical P/E and historical growth rate are also used to see where the stock has traded in the past).

4. Return on Invested Capital (ROIC)

This valuation technique measures how much money the company makes each year per dollar of invested capital. Invested capital is the amount of money invested in the company by both stockholders and debtors. The ratio is expressed as a percent, and the Return on Invested Capital ratio should have a percent that approximates the expected level of growth. In its simplest definition, this ratio measures the investment return that management can get for its capital. The higher the number, the better the return.

5. Return on Assets (ROA)

Like ROIC, ROA, expressed as a percent, measures the company's ability to make money from its assets. To measure the ROA, take the pro forma net income divided by the total assets. However, because of very common irregularities in balance sheets (due to things like goodwill, write-offs, discontinuations, etc. ), this ratio is not always a good indicator of the company's potential. If the ratio is higher or lower than expected, look closely at the assets to see what could be overstating or understating the figure.

6. Price to Sales (P/S)

This figure is useful because it compares the current stock price to the annual sales. In other words, it tells you how much the stock costs per dollar of sales earned.

7. Market Cap

Market Cap, short for Market Capitalization, is the value of all the company's stock. To measure it, multiply the current stock price by the fully diluted shares outstanding.

8. Enterprise Value (EV)

Enterprise Value is equal to the company's total value as traded on the stock market. To compute it, add the Market Cap (see above) and the company's total net debt.

9. EBITDA

EBITDA stands for earnings before interest, taxes, depreciation, and amortization. It is one of the best measures of a company's cash flow and is used to value both public and private companies.

10. EV to EBITDA

This is perhaps one of the best measurements of whether or not a company should be valued as cheap or expensive. To compute, divide the EV by EBITDA (see above for calculations). The higher the number, the more expensive the company is.

Valuing Nonconstant Growth Dividends

Limited high-growth approximation, implied growth models, and the imputed growth acceleration ratio are used to value nonconstant growth dividends.

Limited High-Growth Period Approximation

When a stock has a significantly higher growth rate than its peers, it is sometimes assumed that the earnings growth rate will be sustained for a short time (say, 5 years), and then the growth rate will revert to the mean. This is probably the most rigorous and practical approximation.

While these DCF models are commonly used, the uncertainty in these values is hardly ever discussed. Note that the models diverge and hence are extremely sensitive to the difference between dividend growth and discount factor. One might argue that an analyst can justify any value (and that would usually be one close to the current price supporting his call) by fine-tuning the growth/discount assumptions.

Implied Growth Models

One can use the Gordon model or the limited high-growth period approximation model to impute an implied growth estimate. To do this, one takes the average P/E and average growth for a comparison index, uses the current (or forward) P/E of the stock in question, and calculates what growth rate would be needed for the two valuation equations to be equal. This gives you an estimate of the "break-even" growth rate for the stock's current P/E ratio. (Note: we are using earnings, not dividends, here because dividend policies vary and may be influenced by many factors, including tax treatment).

Imputed Growth Acceleration Ratio

Subsequently, one can divide this imputed growth estimate by recent historical growth rates. Suppose the resulting ratio is greater than one. In that case, the stock would need to experience accelerated growth relative to its recent historical growth to justify its current P/E (higher values suggest potential overvaluation).

Suppose the resulting ratio is less than one. In that case, it implies that the market expects growth to slow for this stock or that it could sustain its current P/E with lower than historical growth (lower values suggest potential undervaluation).

Comparison of the IGAR across stocks in the same industry may give relative value estimates. IGAR averages across an industry may give estimates of relative expected changes in industry growth (e.g., the market's imputed expectation that an industry is about to "take off" or stagnate). Naturally, any differences in IGAR between stocks in the same industry may be due to differences in fundamentals and would require further specific analysis.