Firm-foundation theorists view the worth of any share as the present value of all dollar benefits the investor expects to receive from it. The starting point focuses on the stream of cash dividends the company pays. The worth of a share is taken to be the present or discounted value of all the future dividends the firm is expected to pay.
The price of a common stock is dependent on several factors:
I. Determinant 1: the expected growth rate:
1. Dividend growth does not go on forever. Corporation and industries have life cycles similar to most living things. Furthermore, there is always the fact that it gets harder and harder to grow at the same percentage rate.
2. Rule 1: A rational investor should be willing to pay a higher price for a share the larger the growth rate of dividends and earnings.
3. Corollary: A rational investor should be willing to pay a higher price for a share the longer an extraordinary growth rate is expected to last.
II. Determinant 2: The expected dividend payout.
1. The higher the payout, other things being equal, the greater the value of the stock. The catch is “other things being equal.” Stocks that pay out a high percentage of earnings in dividends may be poor investments if their growth prospects are unfavorable. Conversely, many companies in their most dynamic growth phase often pay out little or none of their earnings in dividends.
2. Rule 2: A rational investor should be willing to pay a higher price for a share, other things being equal, the larger the proportion of a company’s earnings that is paid out is cash dividends.
III. Determinant 3:
Rule 3: A rational (and risk-averse) investor should be willing to pay a higher price for a share, other things being equal, the less risky the company’s stock.
IV. Determinant 4: the level of market interest rates:
Rule 4: A rational investor should be willing to pay a higher price for a share; other things being equal, the lower are interest rates.
V. Two Caveats
Caveat 1: expectations about the future cannot be proven in the present. Predicting future earnings and dividends requires not only the knowledge and skill of an economist but also the acumen of a psychologist. And it is extremely difficult to be objective.
Caveat 2: Precise figures cannot be calculated from undetermined data. You can’t obtain precise figures by using indefinite factors.
VI. Testing the rules
1. The 2002 data shows that high P/E ratios are associated with high expected growth rates.
2. Fundamental considerations do have a profound influence on market prices. P/E ratios are influenced by expected growth, dividend payouts, risk, and the rate of interest. Higher anticipations of earnings growth and higher dividend payouts tend to increase P/E. Higher risk and higher interest rates tend to pull them down. There is logic to the stock market, just as the firm foundationists assert.
3. It appears that there is a yardstick for value, but one that is a most flexible and undependable instrument. Stock prices are in a sense anchored to certain “fundamentals,” but the anchor is easily pulled up and then dropped in another place. The standards of value are the more flexible and fickle relationships that are consistent with a marketplace heavily influenced by mass psychology.
4. The most important fundamental influence on stock prices is the level and duration of the future growth of corporate earnings and dividends. But, future earnings growth is not easily estimated, even by market professionals.
5. Dreams of castles in the air may play an important role in determining actual stock prices. And even investors who believe in the firm-foundation theory might buy a security on the anticipation that eventually the average opinion would expect a larger growth rate for the stock in the future.
6. It seems that both views of security pricing tell us something about actual market behavior.
A Random Walk Down Wall Street - The Get Rich Slowly but Surely Book Burton G. Malkiel