Dividend Discount Model Revisited

As documented in Chapter Seven, one method of stock valuation is the dividend discount model in which all future dividends are forecasted and then discounted back to today. From a theoretical perspective this is an incredibly sound, simple (okay, maybe not so simple when you are first learning it -- but it IS easier than quantum physics) technique. Stockholders receive dividends as compensation for investing their capital into the corporation. The price they are willing to pay for these shares should be equal to the compensation they are going to receive. However, since they are going to receive the compensation over a long period of time, we must use present value techniques to find out what the compensation is worth today. This sets up a simple (in theory) valuation process of forecasting dividends and then discounting them back at an appropriate risk-adjusted discount rate.

While this is indeed theoretically sound and relatively straight-forward, it is much more difficult to implement than it is to solve in a textbook. First of all, we need to forecast ALL of the future dividends that the firm is EVER ever going to pay. Not just in our lifetimes, but in the firm's lifetime. While assuming a constant rate makes the whole process very easy, it is also incredibly unrealistic. It's somewhat similar to me assuming that I know what next week's PowerballTM numbers are and quitting my job today since I will be a multi-millionaire next week. Life would be real easy if it worked like that, but it doesn't.

The next issue with the dividend discount model is that it assumes firm's are going to be paying dividends. However many high growth firm's pay no dividends (or close to it) and instead use their profits to finance future growth. Despite this lack of dividends, they can be great investments. For example, if you would have purchased 100 share of eBay when it went public at its closing price on the first day of trading ($47.38 per share or $4738 on September 24th, 1998), you would now own 1,787 shares at a total value (as of April 18, 2007) of $62,902. In this time you would have received no dividends. As mentioned earlier, one reason for not paying dividends is to finance company growth. In eBay's case, this has included many upgrades in hardware and software to support their auction site, the purchase of Paypal and Skype, along with far too many other projects to mention. If eBay would have been using its cash to pay dividends instead of on developing projects its hard to imagine them being where they are today. Another reason for not paying dividends (even many firms that can't be characterized as high growth are pay out less than 50% of their earnings in the form of dividends) is that there have historically been tax disadvantages to investors associated with receiving dividends relative to capital gains. However two factors are currently leading to a comeback in dividends. First, the stock market declines of 2000-2002 made many investors more interested in dividends as a more stable form of income from stocks than capital gains. Second, a significant reduction in the tax rate on dividend income has reduced the tax penalty to dividends. Despite this shift back towards dividends, there are still a large number of firms that do not pay dividends at all or pay only very small dividends. Capital Gains are still the dominant form of return for most stocks.

If dividends are not being paid (or are really small), why do stocks such as eBay increase in value so rapidly? Cash flows. Even though eBay has not historically paid dividends to its shareholders, the cash flow generated by eBay still belong to the shareholders. The shareholders are willing to forego the dividend payment today in order to allow eBay to reinvest those cash flows. As long as eBay can earn a higher risk-adjusted rate of return on those cash flows than investors could earn on the dividends they would have received this is a win-win situation. Those investors that want to cash out can do so by selling their shares to other investors. Therefore, investors don't really look at the dividends being paid out, but at the cash flows being generated by the firms.

In summary, we have two problems with the dividend discount model in practice. One is that it may be more appropriate to use a cash-flow discount model. Fortunately, that is not much of a problem, just use cash-flow forecasts instead on dividend forecasts. Unfortunately, we still must estimate ALL the cash flows that will ever be earned in the firm's lifetime (this is the second problem). This is a virtually impossible task. While the dividend (cash flow) discount model is still a relevant framework, many people have developed alternate valuation methods to make decisions on which stocks to buy and which to sell in the stock market. I will discuss some of these below
Price/Earnings (PE) Ratios

One way to determine if a stock is cheap or expensive is to look at its price/earnings (PE) ratio. Remember from our financial ratios that this is just the stock price divided by the earnings per share. This number essentially tells us how much we are paying for each $1 that the stock is earning. Everything else being equal, the lower the PE ratio the cheaper the stock. Have you ever noticed how often you see "everything else being equal" in a textbook compared to how often everything else truly is equal? This is a classic example of a dangerous phrase because in most cases things are not equal. For example, consider two stocks. Stock A has a PE of 5 while Stock B has a PE of 15. Which is cheaper? The answer is "it depends". What does it depend on? First, how are earnings calculated. Second, how fast are earnings growing. Third, how risky are those earnings.

Typically PE ratios are typically reported using earnings before extraordinary items. Extraordinary items are those transactions which are thought to be one-time in nature and thus not a reliable indicator of the "earnings stream." For example, a firm may undergo a restructuring. They might "streamline" their operations by cutting 2000 jobs. This will likely generate large transitory expenses (severance packages, etc.), but this expense is designed to lower expenses in the future and is therefore considered an extraordinary item. Another issue with earnings is when do we start and stop. We could use the last four quarters to calculate EPS. This allows us to use real numbers instead of forecasts. We could use next year's forecasted earnings. This allows us to be "forward-looking" instead of being "historical." What if our firm was profitable last year, but business is rapidly turning downward? Using last year's EPS would make our stock look cheap when it really isn't. Forecasted earnings avoid that, but at the expense of using estimates instead of exact numbers. A third way would be to split the difference and use the last two quarters of actual earnings and the next two quarters of forecasted EPS. Most investors prefer to look at EPS based on forecasted earnings. Be careful when looking at PE ratios reported by someone rather than calculated yourself to make sure you know how EPS are calculated. It can make a huge difference.

The second thing to consider about PE ratios is growth. Typically, the higher the growth rate in earnings, the greater the PE ratio. This is somewhat intuitive and relates closely to what we see in the dividend discount model. In the dividend discount model, we see that the present value of dividends is worth more if those dividends are growing faster. The same thing happens with PE ratios. Investors are willing to pay more for each dollar of earnings, as those earnings are growing faster. Consider two companies. Company A has EPS of $1 and they are expected to have no growth. Company B currently has EPS of $0.50, but expects earnings to grow at 20% per year for the next 5 years. Which stock is worth more? Let's fast-forward 5 years. Company A will still be earning $1 per share. Company B, on the other hand, will now be earning $1.24 per share. Company B's growth rate makes each $1 of current earnings worth more and therefore it should have a higher PE ratio. How much should we pay for growth? That is a tricky question, but some people have developed a simple rule of thumb that says if the PE ratio should be approximately equal to the growth rate. This is the ratio of PE to growth is sometimes called the PEG ratio. Be careful that while this is a simple rule, it is probably too simple. When interest rates are low, growth is more valuable (this again borrows from time value of money as future earnings become more valuable as they are discounted at a lower rate). Also, predictable growth is more valuable than unpredictable growth (this is an illustration of risk-aversion). Thus, investors may be willing to pay more (on a PE basis) for a company like Coca-Cola or Microsoft that has a strong history of growth than a small, upstart firm with the same growth rate.

Closely related to the predictability of growth is the predictability of earnings. If Company A can grow earnings at 10% per year and do this year-in, year-out that is very valuable to investors. Few firms can do this consistently, but many firms get involved in the questionable practice of "income smoothing" to help achieve this goal. If Company B is expected to grow earnings at 10% per year, but that number may be 20% or may be 0%, this is less valuable to investors. Again, this is an illustration of risk aversion.

A quick review of PE ratios. Lower PE ratios are considered cheaper (as we are paying less for each $1 of earnings that the company is making). The PE ratio is useful as it allows us to compare different companies on a common denominator. For example if Company A's stock sells for $50 per share and Company B's stock sells for $25 per share stock A seems to be twice as expensive as stock B. However, if Company A is making $2.50 per share while Company B is making $1.25 per share, they both are being valued at an equivalent basis. Its similar to buying a 12-pack of soda vs a 24-pack. The important thing is what are we paying per can, not what are we paying total. While the PE ratio is a common value for comparison, we need to be careful since there are good reasons why some PE's can be higher than others and still more attractive to us as investors. Higher quality earnings (less risky and/or faster growth) are worth more and investors will rationally pay more for them (just like a can of Mountain Dew sells for more than a can of generic pop). What is a fair PE ratio? That is something each individual must make for him/herself based on risk, growth, interest rates, and how earnings are calculated.

Fundamental Analysis

Fundamental Analysis describes the process of trying to uncover the underlying value of a corporation, break that down into a per share basis, and then see if the stock is "cheap" or "expensive" relative to its fundamental value. Critical to the concept of fundamental analysis is the concept that when you buy a share of stock, you are buying a piece of a business. Even though it is a small piece, it is partial ownership of a business that is designed to generate cash flows to its owners. Really, fundamental analysis is a detailed version of the dividend discount model, substituting cash flows for dividends.

Many books have been written by very smart people on how to perform fundamental analysis and there is far too much involved for me to go cover it all here. If you are interested in three books that I can recommend are

• "Security Analysis" by Benjamin Graham and David Dodd. This is considered to be THE book on fundamental analysis (although the original is rather old -- 1934 -- there have been a few updates if you purchase a new edition).
• "Beating the Street" by Peter Lynch. This is a book that explains the investment style of one of the greatest investors of our time (well, probably more "my" time than yours.) It is the most "fun" of the three books in that it has a lighthearted, easy-to-read style, but is still very informational.
• "The Warren Buffett Way: Investment Strategies of the World's Greatest Investor" by Robert G. Hagstrom, Jr. While not written by Buffett ("The Oracle of Omaha"), who is the most successful investor of our time, it attempts to explain his investment style.

Of these three, the one I'd most recommend for the beginning or casual investor would be the Lynch book.

While, as mentioned above, there is far too much involved in fundamental analysis to give a complete explanation, I will try to touch on a few points. Keep in mind that this is a VERY brief and simplified presentation.

First, in order to perform fundamental analysis, you should understand the nature of the business you are valuing. This is critical. Warren Buffett has stated many times that he refuses to invest in some companies solely because he does not feel that he understands their product well enough. Peter Lynch's philosophy stressed in his book is to look for stocks in fields that you know well. Remember, you are buying a portion of the business. If you don't understand the business how can you tell if it is worthwhile to own a piece of it. For example, if you work in the Information Technology field, you should have a good idea of what companies are the leaders, what products work well and what products have serious flaws, what products sell well, what new products or technologies are being developed and who will profit from them. Here is a more specific example. Consider the company Hasbro, a toy company. If you work for a toy store, you have a considerable advantage in investing in this company. Are their products selling well or is unsold inventory starting to build up? Be careful though to recognize that your store is just one data point. Think of this information as a starting point, not a stopping point. Don't buy stock in Chipotle, just because you like their burritos. However, see the next two paragraphs as I expand on this point.

Second, it is not enough to like the product or notice that the product is selling well. That is merely the beginning. How is the company going to make money off of its product? Does it have strong enough management to allow it to grow? Are costs being kept under control? Does it have deep-pocketed competition? Does the stock price already reflect a "best-case" scenario? How important is the product to the company's bottom line? Remember, you are buying a piece of the company. You must consider all these factors when making a decision in whether or not you want to own some of the company AND how much are you willing to pay to do so.

Third, you must know the financials. You need to understand the income statement and balance sheet. Both what they are telling you up front and what they are telling you between the lines. Are higher sales leading to higher profits? Maybe, but what if those are credit sales that will never get collected? Is the firm starting too build too much inventory that will have to be sold for a loss in the future? A solid background in accounting can really help with the analysis of the financial statements. There is often a lot more there than meets the eye.

What isn't in the financial statements. What about new products that are going to have a major impact on future sales? How about potential lawsuits? What about assets like brand names (Intel, Coca-Cola, McDonalds, etc.)? There are many important factors that affect the value of a business that are not adequately captured by the financial statements

As you can see, fundamental analysis is hard work. You need to try to look at all the factors that will help the company make money not just today, but in the future. Then, you need to estimate how much the firm is worth based on all the information. Finally, you have to see if the stock price is trading for more or less than the value you place on it. Then to really top things off, what if you determine that the stock is worth $40 and it is trading for $30. Does that mean that you should buy the stock or does it mean that other investors know something negative about the company that you missed?

Two subcategories of fundamental analysis are value investing and growth investing. Value investors look for stocks that are cheap. Specifically, value investors look for situations where the value of the stock is less than the value of the firm's underlying assets. These stocks typically have low PE ratios and low MV/BV ratios (market-value divided by book-value). There is some academic support for this as many studies have indicated that these stocks earn higher than risk-adjusted rates of return. "Security Analysis" by Graham and Dodd is the bible of most value investors.

Growth investors are not necessarily looking for "cheap" stocks, but instead stocks of companies that are growing rapidly. Their viewpoint is less on the value of the underlying assets and more on the value of cash flows that will be generated in the future. Many of these stocks may appear expensive based on current earnings, but growth investors feel that future earnings will increase fast enough to justify the price paid today. Growth stocks have above-average expected growth rates in sales and/or earnings. If you consider some of the top growth stocks of the last fifteen years (Google, Microsoft, Genentech) it is hard to argue with this strategy. However, many top growth stocks flame-out and can't adapt to their increased size which eventually destroys them. Thus growth investors have to recognize that they will make some bad selections, but count on the home runs to offset the strikeouts. Also, when growth stocks start to slow down (Dell Computers and Wal-Mart are recent examples) they can see their price either fall quickly or stay stagnant for years. While many people think of Wal-Mart as a very successful company (and by most standards they are correct), from Oct. 1999 through April 2007 (when I last updated this), Wal-Mart investors have essentially had no return on their investment.
Technical Analysis

Technical Analysis is the outcast of the investment world in the realm of academics, but a primary tool used by many investors. The foundation of technical analysis is based on trying to gauge supply and demand conditions for stocks as opposed to determining the underlying value of the company. Technical Analysts argue that the fundamentals are irrelevant (actually many TA people don't think the fundamentals are irrelevant just that we are unlikely to be able to evaluate them better than everyone else) and what matters is whether there is more buying pressure or selling pressure.

Most folks in TA believe that the supply and demand issues can be analyzed by looking at various charts. They will look for lines of support and resistance in the stock prices. They will also look for specific trading patterns in these charts that signify the future. For example, one classic chart pattern is a double-bottom. Consider a stock that drifts down from $20 to $15, then slides up to $18, then again drifts down to $15.50 and starts to move back up again. This takes place over the time span of a few weeks. A technical analyst might see this as sign that there is "support" for the stock at $15 per share. Once it drops to this price, new buyers will step in and start pushing the price back up. Even better, note that it only dropped to $15.50 the second time around. This indicates that buyers were more eager to step in. These tells the investor that the stock will have a hard time falling below $15 per share as there is a considerable amount of demand for the stock at that price. What happens if it falls below $15? Then we have to look out below because we have "broken support."

The above is a somewhat simplified look at technical analysis there are many factors besides simple support and resistance that these investors look at. However, all of them focus on looking for patterns in the price (and sometimes volume) behavior of a stock to signify supply and demand conditions and give them a view of where the stock might be headed. As a side note, I have little confidence in the effectiveness of TA. While many people use it, indicating that it may indeed have some value, I have seen little evidence of its effectiveness. Also, it is described by some of its most ardent practitioners as somewhat of an art form over a science as many times the patterns are open to interpretation. If you are interested in finding out a lot more about technical analysis, Stockcharts.com has an excellent Chart School Page that covers a lot of TA basics.
Other Stock Buy/Sell Methodologies

Everything but the kitchen sink has been used to try to develop stock trading strategies -- even "the moon and stars". There are some investors that actually have attempted to use astrology to make their investment decisions. Others base decisions on cycles that are based purely on number patterns. All of this may work occasionally, but so does asking a two-year old to point her finger at the newspaper stock selections. A broken clock is right twice a day. Some of the more approaches I feel are more legitimate are listed below.

Some investors try to track insider purchases. While this will not give a "value", it could be used to make a buy/sell decision. Corporate executives must report their buying and selling activity to the SEC and this information is then made public. There is some sound logic to this. Who would no more about what the company is truly worth than the people that spend their careers making decisions for the company? Obviously they have more and better information than the rest of us. Unfortunately there are two downsides to this. First, there is a long delay between the time that the insider makes the buy/sell decision for their portfolio and the investing public finds out about it. Things can change dramatically in this time. Second, there are many reasons an executive may decide to sell shares that don't signify that they think the company's prospects are bad. Thus, they may have received $1 million in shares as part of their compensation package and want to spend some of this money, so they sell their shares. Despite these flaws, insider purchases may be a useful piece of information to include in making a buy/sell decision, but I wouldn't recommend it as the only piece.

Many investors are what we refer to as "momentum" investors. They buy stocks that are doing well and sell stocks that are doing poorly. The idea is that as a stock goes up it will start attracting attention creating further demand and going up further. As a stock goes down, investors that are holding that stock and losing money will sell to cut their losses and drive the stock down further. This is really a variation on technical analysis and is commonly used by short-term investors. However, there have been several academic studies that have shown that stocks that have outperformed the market over the past 6-12 months have higher average returns over the next 6-12 months than the average stock.

Bottom-fishing is the opposite of "momentum" plays. These investors like to buy stocks that have fallen dramatically from their highest levels. The idea is that they have been just given the opportunity to buy shares on a "clearance sale." As the company recovers from whatever caused the price to fall so dramatically the investors that bought at the lows can make a big return. The risk here is that some of the stocks are down for good reason and sometimes end up going bankrupt or staying at the low levels for years. The academic studies in support of these Contrarian approaches tend to find greater success over longer time frames. In other words, don't focus on poor performers over the last 6-12 months, but instead 3-5 years.

Focusing on small firms may offer higher returns. There is a history of academic studies that show the smallest firms tend to earn higher returns than average. This may be due to the idea that institutional investors are not likely to place as much attention on these stocks and this could lead to under valuation. However, it is also quite possible that these higher returns are somewhat of an illusion in that they may be more costly to trade and to gather information on. Also, there is reason to believe that they are riskier so that the higher returns may be more a compensation to risk as opposed to a "bonus" return.
Behavioral Finance

The concept of the dividend/cash flow valuation methodology relies on the concept that investors are rational. They can make sound decisions based on time value of money, unbiased forecasts of future cash flows, and an application of risk-adjusted returns. However, there is growing evidence that investors (and people in general) are not rational. Specifically, investors hate to sell for a loss. This means that they tend to hold onto their poor decisions waiting for them to "bounce back" even if the reasons that they bought the stock are no longer valid. Also, we tend to be overconfident. There is a lot of random luck in the investment world. However, we tend to chalk-up our bad decisions to bad luck and reason that all our good decisions are a result of our genius. This can create a case where we are less diligent in learning from our mistakes. Also, we don't treat "paper" profits the same as real money. If I buy a stock and it goes from $10 per share to $40 a share, I have made a "paper" profit of $30. However, if I sell the stock it is no longer a paper profit, but real money. If I don't sell it and the stock drops down to $20 per share, I have just lost $20. However, most investors still see themselves as up $10 and don't count the decline from $40 to $20 as relevant. There are many other behavioral tendencies that distort our investment making decisions and keep us from operating rationally.
Summary

The above is just a brief exposure to the world of investing in the stock market. There are countless different investment strategies. The reason for this is that there is a lot of randomness in the stock market. It in essence requires us to forecast the future and there is quite a bit of the future that is unknowable. Because of this randomness, it is very difficult to distinguish a good investing methodology from a poor one. Further, the more efficient markets are the less advantage we can gain from a good investing methodology and the less we will lose from making investment decisions by flipping a coin. Put 1000 people in a room and ask them to flip a coin with Heads being good and Tails being bad. After 5 flips, pull aside the people that ended up with 4 or 5 Heads in one group and the people that got 0 or 1 heads in another. Are one set "good" coin flippers and the other group "bad"? Is there a special technique that allows them to flip more heads? What if a few of the people from the "good" group said that they blew on the coin before flipping our blinked their eyes three times while the coin was in the air? Should we follow their technique to help us flip a head? Its difficult to separate lucky from good and we want to be careful to try to learn from those that are good and not just lucky. My belief is that those strategies based on understanding the company and buying good businesses for a fair price are the only way to make decisions. Your mileage may vary.