80 Stock Valuation

A no-growth company would be expected to return high dividends under traditional finance theory.

The Dividend Decision

Whether to issue dividends and what amount is calculated mainly on the basis of 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 return 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 so as 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 stock holder more than another; this is sometimes called the “clientele effect. ” A retiree may prefer to invest in a firm that provides a consistently high dividend yield, whereas a person with a high income from employment may prefer to avoid dividends due to their high marginal tax rate on income. If clienteles exist for particular patterns of dividend payments, 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

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

Expected Dividends and Constant Growth

Valuations rely heavily on the expected growth rate of a company; past growth rate of sales and income provide insight into future growth.

Growth Rate

Valuations rely very heavily on the expected growth rate of a company. One must look at the historical growth rate of both sales and income to get a feeling for the type of future growth expected. However, companies are constantly changing, as well as the economy, so solely using historical growth rates to predict the future is not an acceptable form of valuation. Instead, they are used as guidelines for what future growth could look like if similar circumstances are encountered by the company. Calculating the future growth rate requires personal investment research. This may take form in listening to the company’s quarterly conference call or reading a press release or other another company article that discusses the company’s growth guidance. However, although companies are in the best position to forecast their own growth, they are far from accurate. Unforeseen events could cause rapid changes in the economy and in the company’s industry.

And for any valuation technique, it’s important to look at a range of forecast values.

• For example, if the company being valued has been growing earnings between 5 and 10% each year for the last five years, but believes that it will grow 15 – 20% this year, a more conservative growth rate of 10 – 15% would be appropriate in valuations.
• Another example would be for a company that has been going through restructuring. They may have been growing earnings at 10 – 15% over the past several quarters / years because of cost cutting, but their sales growth could be only 0 – 5%. This would signal that their earnings growth will probably slow when the cost cutting has fully taken effect. Therefore, forecasting an earnings growth closer to the 0 – 5% rate would be more appropriate rather than the 15 – 20%. Nonetheless, the growth rate method of valuations relies heavily on gut feel to make a forecast. This is why analysts often make inaccurate forecasts. It is also why familiarity with a company is essential before making a forecast.

Sum of Perpetuities Method

The PEG ratio is a special case in the Sum of Perpetuities Method (SPM) equation. A generalized version of the Walter model (1956), SPM considers the effects of dividends, earnings growth, as well as the risk profile of a firm on a stock’s value. Derived from the compound interest formula using the present value of a perpetuity equation, SPM is an alternative to the Gordon Growth Model. The variables are:

• P is the value of the stock or business
• E is a company’s earnings
• G is the company’s constant growth rate
• K is the company’s risk adjusted discount rate
• D is the company’s dividend payment

Constant Growth Approximation

The Gordon model or Gordon’s growth model is the best known of a class of discounted dividend models. It assumes that dividends will increase at a constant growth rate (less than the discount rate) forever. The valuation is given by the formula:

The portion of the earnings not paid to investors is, ideally, left for investment in order 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 that that investors take into account 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 as 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 in order to provide for future earnings growth.

Some companies require large amounts of new capital just to continue operations. Such firms are usually unable to distribute earnings, since their funds are tied up in maintenance, repairs, et cetera. 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 in order 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 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 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 that are judged as undervalued (with respect to their theoretical value) are bought, while stocks that are perceived to be overvalued are sold, in the expectation that undervalued stocks will, on the whole, rise, while overvalued stocks will, on the whole, fall.

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 to take each approach into account while formulating an overall opinion of the stock. If the valuation of a company is lower or higher than other similar stocks, then the next step would be to determine the reasons for the discrepancy.

1. Earnings Per Share (EPS)

EPS is the total net income of the company 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 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 is able to get for its capital. The higher the number, the better the return.

5. Return on Assets (ROA)

Similar to 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, be sure to 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, which is short for Market Capitalization, is the value of all of 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 total value of the company, as trading on the stock market. To compute it, add the Market Cap (see above) and the total net debt of the company.

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 for valuing 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 approximation that is practical.

While these DCF models are commonly used, the uncertainty in these values is hardly ever discussed. Note that the models diverge for and hence are extremely sensitive to the difference of dividend growth to 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. If the resulting ratio is greater than one, it implies that the stock would need to experience accelerated growth relative to its prior recent historical growth to justify its current P/E (higher values suggest potential overvaluation). If the resulting ratio is less than one, it implies that either the market expects growth to slow for this stock or that the stock 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 estimates of relative value. 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.