How do you value an investment, something that you are thinking about putting your own savings into? What factors or variables do you need to know to determine a valuation? This is the first of at least a two-part (and possibly more) blog post on valuation methodologies. I hope to show you what the “textbook” methodologies are and how to make sense of them, and then to discuss what works in today’s market and what doesn’t work, and why.
Constant Dividend Growth Model
The most basic valuation equation is called the Constant Dividend Growth Model, which is as follows:
Value = Dividend/(Rate of Return – Growth)
Thus, you need to know the company’s or the investment’s dividend (for the next year) and the dividend’s projected growth rate, as well as the rate of return that you want to earn on this investment. Does that mean you should look up a company’s dividend and use that as the numerator in the equation? No, it doesn’t. “Dividend” in this equation means all of the cash flow generated in the next year by this company or this investment. Think about if you are looking at buying a 4 unit apartment building. Let’s say you think you can get $1,000/month for those units, and that you think you can raise rents 2% per year. In this case, your Revenues would be $1,000 times 4 times 12 months, or $48,000 per year. However, you have to pay some operating expenses to achieve those rents, such as property management fee, property taxes, insurance, and repairs. Do not include interest on a loan – that is a different category of expense. Those operating expenses typically add up to 40% of revenues, so that your cash flow, or “Dividend”, to be used in the numerator of the equation, would be as follows:
Expenses (40%): (19,200)
Cash Flow: $28,800
So, $28,800 is your “Dividend” for the purposes of this equation. Now let’s say you want to make 8% on this investment. That means your denominator is 8 – (.6)2, or 6.8%. Remember, if you think your rents will go up 2%, so will your expenses, and if you pocket 60% of your income, your true growth rate is 60% of 2%, or 1.2%. That means you would pay $28,800 divided by .068, which is $423,529 for this entire 4 unit apartment project.
Why am I using an apartment building as an example? Because the finance textbook says you should use the same equation if you buy a stock, and I think a 4 unit apartment building is easier to identify with than is an investment in a stock. Remember: When you buy stock in a company, that means you own that fractional percentage of the company. It’s yours! Same as when you buy 100% of an apartment building. It’s yours!
Is it Practical?
Is the Constant Dividend Growth Model a practical way to go about figuring out what price you should pay for a stock? No, it is not. Why not? Because, as an individual investor, purchasing a 100 or a 1,000 share lot of or interest in a company, you are not at all in control of all of the cash flow or even of your fractional percentage of cash flow from the company that you own. The company’s management is in charge of determining how much cash flow the company will keep and how much it will distribute to the shareholders. This is something called the Dividend Payout Ratio: the percentage of a company’s cash flow that gets paid out to its shareholders. Currently the Dividend Payout Ratio for the S&P 500 is approximately 40%. That means on average that S&P 500 (i.e. large) companies pay out 40% of the cash flow they earn to their shareholders and keep the other 60% and re-invest it back into the company, presumably to try to increase future cash flows. You are a shareholder, but when it comes to deciding how to allocate cash flows, you are along for the ride. Don’t like how management allocates its cash flows? Talk to other shareholders and convince them to fire or vote out management. Is that an easy thing to do? No, it is very difficult.
Another reason the equation is not practical is because it is very difficult to determine what a company’s actual cash flow is. This is because of accounting rules. Things like depreciation, amortization, capital expenditures, and even taxes are governed by accounting rules that make it very difficult for the average investor who is not a CPA or finance professional to decipher. This is one reason why you need the Stock Analyst. It is partly the Stock Analyst’s job to calculate a company’s cash flow and to make a call up or down as to whether that cash flow is sustainable or not.
As with most equations or theories from academe, the Constant Dividend Growth Model is a good rule of thumb but not very practical, especially for the typical individual investor, because of the lack of control over the cash flows and opaque accounting rules. Use it when you make a simple investment and you will control all of it. Don’t rely on it if you are a minority shareholder.
Next posts will include discussion of a cousin of the Constant Dividend Growth Model called the Discounted Cash Flow Model, as well as a discussion of one prominent investor who does use these models, and why he is able to be successful using them. I bet you can guess who that prominent investor is.