Monday, 26 December 2016

A Dividends-and-Earnings (D&E) approach to Stock Valuation

A Dividend-and-Earnings approach

One valuation procedure that is popular with many investors is the so-called dividends-and-earnings (D&E) approach, which directly uses future dividends and the future selling price of the stock as the relevant cash flows.

The value of a share of stock is a function of the amount and timing of future cash flows and the level of risk that must be taken on to generate that return.

The D&E approach (also known as the discounted cash flow or DCF approach) conveniently captures the essential elements of expected risk and return and does so in a present value context.

Value of a share of stock
= Present value of future dividends + Present value of the price of the stock at the date of sale.

The D&E estimates the future stock stock price by multiplying future earnings times a P/E ratio.

Because the D&E calculation does not require a long-run estimate of a stock's dividend stream, it works just as well with companies that pay little or nothing in dividends as it does with stocks that pay out a lot of dividends.

Finding a viable P/E multiple is critical in the D&E approach

Using the D&E valuation approach, we focus on projecting 

  • future dividends and 
  • share price behaviour 
over a defined, finite investment horizon.

Especially important in the D&E approach is finding a viable P/E multiple that you can use to project the future price of the stock.

This is a critical part of this valuation process because of the major role that capital gains (and therefore the estimated price of the stock at its date of sale) play in defining the level of security returns.

Using market or industry P/E ratios as benchmarks, you should establish a multiple that you feel the stock will trade at in the future.

The P/E multiple is the most important (and most difficult) variable to project in the D&E approach.

Estimates required

Estimate its future dividends
Estimate its future earnings per share
Estimate a viable P/E multiple
Estimate its future price ( = P/E multiple x future earnings per share)
Estimate your required rate of return

Using the above estimates, this present value based model generates a justified price based on estimated returns.

You want to generate a return that is equal to or greater than your required rate of return.


Company ABC
Our investment horizon - 3 years
Forecasted annual dividends  Yr 1 $0.18       Yr 2 $0.24      Yr 3  $0.28
Forecasted annual EPS           Yr 1 $3.08       Yr 2  3.95       Yr 3  $4.66
Forecasted P/E ratio                Yr 1 20.0         Yr 2 20.0        Yr 3  20.0
Share price at year end of        Yr 1 $61.60     Yr 2 $75.06    Yr 3  $93.20

Given the forecasted annual dividends and share price, along with a required rate of return of 18%, the value of Company ABC stock is:

Value of a share of stock
= Present value of future dividends + Present value of the price of the stock at the date of sale.

= {[$0.18/(1.18)] + [$0.24/(1.18^2)] + [(0.28/(1.18)^3]}    +     [$93.20/(1/18^3)]
= {$0.15 + $0.17 + $0.17}    +    $56.72
= $57.22

According to the D&E approach, Company ABC's stock should be valued at about $57 a share.

Comments on the above example:

1.  Assuming our projections hold up and given that we have confidence in the projections, the present value figure computed here means that we would realize our desired rate of return of 18% so long as we can buy the stock at no more than $57 a share.

2.  If Company ABC is currently trading around $41, we can conclude that the stock at present price is an attractive investment.  Because we can buy the stock at less than its computed intrinsic value, we will earn our required rate of return and then more.

3.  Note:  Company ABC would be considered a highly risky investment, if for no other reason than the fact that nearly all the return is derived from capital gains.  Its dividends alone account for less than 1% of the value of the stock.  That is only 49 cents of the $57.22 comes from dividends.

4.  If we are wrong about EPS or the P/E multiple, the future price of the stock would be way off the mark and so too, would our projected return.

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