Stock valuation. Why does the value of a share of stocks depend on dividends?

Does the value of stocks depend on dividends or earnings?

Management determines its dividend policy by evaluating many factors, including:

• the tax differences between dividend income and capital gains,
• the need to generate internal funds to retire debt or invest, and,
• the desire to keep dividends relatively constant in the face of fluctuating earnings.

Since the price of a stock depends primarily on the present discounted value of all expected future dividends, it appers that dividend policy is crucial to determining the value of the stock.

However, this is not generally true. It does not matter how much is paid as dividends and how much is reinvested AS LONG AS the firm earns the same return on its retained earnings that shareholders demand on its stock. The reason for this is that dividends not paid today are reinvested by the firm and paid as even larger dividends in the future.

Dividend Payout Ratio

Management's choice of dividend payout ratio, which is the ratio of cash dividends to total earnings, does influence the timing of the dividend payments. 

The lower the dividend payout ratio (that is more earnings are retained), the smaller the dividends will be in the near future. Over time, however, dividends will rise and eventually will exceed the dividend path associated with a higher payout ratio.

Moreover, assuming that the firm earns the same rate on investment as the investors require from its equity (for example, ROE of 15%), the present value of these dividend streams will be identical no matter what payout ratio is chosen.

How to value Stocks?

Note that the price of the stock is always equal to the present value of ALL FUTURE DIVIDENDS and not the present value of future earnings. 

Earnings not paid to investors can have value only if they are paid as dividends or other cash disbursements at a later date. Valuing stock as the present discounted value of future earnings is manifestly wrong and greatly overstates the value of a firm. (Note: Firms that pay no dividends, such as Warren Buffett's Berkshire Hathaway, have value because their assets, which earn cash returns, can be liquidated and disbursed to shareholders in the future.)

John Burr Williams, one of the greatest investment analysts of the early part of the centrury and author of the classic The Theory of Investment Value, argued this point persuasively in 1938. He wrote: 

"Most people will object at once to the foregoing formula for valuing stocks by saying that it should use the present worth of future earnings, not future dividends. But should not earnings and dividends both give the same answer under the implicit assumptions of our critics? If earnings not paid out in dividends aree all successfully reinvested at compound interest for the benefit of the stockholder, as the critics imply, then these earnings should produce dividends later; if not, then they are money lost. Earnings are only a means to an end, and the means should not be mistaken for the end."


Ref: Stock for the Long Run, by Jeremy Siegel

http://myinvestingnotes.blogspot.com/2009/05/does-value-of-stocks-depend-on.html

Using PEG ratio: Not all growth is created equal.

As the risk increases, the PEG ratio of a firm decreases. When comparing the PEG ratios of firms with different risk levels, even within the same sector, the riskier firms should have lower PEG ratios than safer firms.

Not all growth is created equal. A firm that is able to grow at 20% a year, while paying out 50% of its earnings to stockholders, has higher quality growth than another firm with the same growth rate that reinvests all of its earnings back. Thus, the PEG ratio should increase as the payout ratio increases, for any given growth rate.

As with the PE ratio, the PEG ratio is used to compare the valuations of firms that are in the same business.  The PEG ratio is a function of:

• the risk,
• growth potential and
• the payout ratio of a firm.

http://zonecours.hec.ca/documents/A2009-1-1877347.ch18-earning-multiple(1).pdf

http://myinvestingnotes.blogspot.com/2009/11/using-peg-ratio-not-all-growth-is.html

The Truth About Stocks for the Long Run

By Alex Dumortier, CFA September 19, 2012

Don't get me wrong. I'm convinced that equities are an appropriate and important component of a long-term strategy to build wealth. However, there are a certain number of popular myths regarding stocks that have taken hold and that can be potentially dangerous to your financial well-being. In this article, I'm highlighting two of them.

Myth 1: Stocks' expected return is 10% to 11% annually
I have seen financial writers and professional investors cite this range (or a figure contained in this range) for the historical average return for stocks innumerable times. That's fine, in principle; the trouble is that they often imply or even assert openly that this is a sound basis for future expected returns.

As far as I can tell, the source for this range may be Long-Run Stock Returns: Participating in the Real Economy (2003), in which Roger Ibbotson of Yale University and his co-author Peng Chen calculate that stocks produced an average return of 10.70% during the period 1926-2000. That's a historical observation (anomaly?) and investors should absolutely not anchor on it when they think about future returns.

That specific period was atypical in a way that can be dangerously misleading if you don't look beyond the "headline" number. Stocks started out at depressed multiples (a price-to-trailing-earnings multiple of 10.2 for the S&P Composite Index) and finished at inflated ones (26.0 for the S&P 500 Index (INDEX: ^GSPC  ) ). All told, the expansion in the multiple's girth alone fattened stocks' average return by a full 1.25 percentage points annually. Unless you have reason to believe that rising valuations will make the same contribution over your investing horizon, expecting the same average return going forward is wrongheaded.

A more realistic benchmark

Taking a longer observation period (January 1871 to August 2012) over which the change in P/E multiple was less dramatic, I found an average return of 8.61%, with the change in P/E contributing just 25 basis points, and inflation 208 basis points (100 basis points being equal to one percentage point).

8.61% - 0.25% - 2.08% = 6.27%

A reasonable historical benchmark with which to begin thinking about future returns is 6% to 7% after inflation. That range is consistent with the long-run stock return estimates in the 2007 edition of Jeremy Siegel's Stocks for the Long Run.

Incidentally, if you don't think a 1.25 percentage point difference is even worth trifling over, consider the end value of a dollar invested at 6.5% over a 30-year period: $6.61. At 7.75%, you'll have $9.38. If you were counting on the higher return and earned the lower one instead, you're now facing a 30% shortfall.

Myth 2: The longer the time horizon, the safer stocks become
This is an idea that has been heavily marketed based on Jeremy Siegel's observation that, historically, the standard deviation of stocks' average returns has fallen as you extend your time horizon. But Siegel himself is pretty cagey when it comes to the broader implications of that finding. This is what he told an audience of financial advisors in 2004:

One thing I should make very clear: I never said that that means stocks are safer in the long run. We know the standard deviation of [stocks'] average [annual return] goes down when you have more periods ... What I pointed out here is that the standard deviation for stocks goes down twice as fast as random walk theory would predict. In other words, they are relatively safer in the long run than random walk theory would predict. Doesn't mean they're safe. [emphasis added]

In a March 2011 paper, Lubos Pastor and Robert Stambaugh, respectively of the University of Chicago and the University of Pennsylvania, show that stocks are more, not less, volatile over long periods.

Siegel compiled historical return data going back over two centuries, and that is fine as far as describing how stocks behaved in the past (strictly speaking, there are problems with this data, to begin with). Pastor and Stambaugh's argument is that observing historical average returns and extrapolating them into the future leaves investors open to "estimation risk." In short, today's investors don't care what stocks did in the past; the only thing that counts is what stocks do in the future, and even two centuries of data does not allow us to know stocks' expected return with certainty. Once you take that uncertainty into account, Pastor and Stambaugh found that stocks are riskier over longer periods.

4 practical recommendations for long-term investors

Don't cling to investing myths such as the two I have highlighted above. Accepting that they are false means recognizing the seas you must navigate are more uncertain and less hospitable than you once thought. It does not mean that throwing up your hands is all that is left to do. Here are four practical recommendations:

• Time horizon is not the only relevant variable in figuring out your allocation between stocks and bonds (and other asset classes). Your risk tolerance, current earnings, and career risk are all things you should consider.
• Use conservative estimates for the equity returns you require in order to achieve your goals to account for "estimation risk."
• Always remain cognizant of valuations -- particularly when they reach extremes (i.e., bubbles).
• Always strive to keep your costs as low as possible; this makes an enormous differenceover time. In that regard, products like the Vanguard Total Market ETF (NYSE: VTI  ) , the Vanguard Dividend Appreciation ETF (NYSE: VIG  ) , and the Vanguard MSCI Emerging Markets ETF (NYSE: VWO  ) are all excellent choices.

http://www.fool.com/investing/beginning/2012/09/19/the-truth-about-stocks-for-the-long-run.aspx

Jeremy Siegel - Efficient Market Theory and the Recent Financial Crisis

Jeremy Siegel Still Invests For The Long Run (Video)

What To Expect From The Market In The Next 8 Years

Mar. 10, 2010

(GuruFocus, March 9, 2010) This much we have a consensus: The current bull market was officially born on March 9, 2009 and market has rallied about 70% since then. What we do not know and we cannot agree on whether we are in a secular bull market or a bear market rally. 

That is the topic of debate between Robert Shiller of Yale University, Jeremy Siegel of University of Pennsylvania’s Wharton School, and Ben Inker of GMO LLC, as it is written up in today’s Wall Street Journal. Shiller and Siegel became friends since their student years in MIT in the 1970s, yet they disagree on which way the market is going.

Shiller, author of famous book Irrational Exuberance in which he warned of the tech bubble before it burst in 2000, is on the bearish side. His reasons, according to the WSJ:

• Despite the two bear markets, stock have spent almost all their time since 1991 priced above historic average. History suggests that when the stock prices are high, performance in ensuing years is disappointing.
• Shiller compiled market data back to 1881, measuring stock prices month by month relative to corporate profits, To avoid short-term profit distortions, he uses an average of profits over the previous 10 years. Over the long run, by his measure, stocks trade at an average of about 16 times annual corporate profits.
• Today the ratio is about 20. Historically, when stock market hit that number, the average return a decade after that is about -2%, adjusted for inflation
• Catalyst for the bearish scenario could be when the government takes away the support in the housing market. Housing market could be turning down after a brief recovery, which could contribute to a decline in U.S. stocks.

Siegel, also author of a well-read book called “Stocks for the Long Run” is on the bullish side. He contends that Shiller’s method of looking at earnings of the past 10 years doesn’t work well in the current environment due to the large write-offs of the financials in 2008. Instead, he prefers to use the forecasted earning:

• When economy came out of recession, the common P/E is 18.5.
• Currently the market is selling at about 14.5 times forecast 2010 profits, making it cheap in comparison to the past after-recession market.
• If the P/E expand to 18.5, S&P could rise to1400 this year, a 23% gain from today’s level.
• What’s more, ”We could easily see 10% to 12% stock returns with low inflation in future years”, Siegel predicts.

Ben Inker, in consistence of the firm’s stance on the matter, presented his arguments from a different angle – he uses historical profit margins to forecast future corporate profits. His reasoning:

• Internet and real estate bubbles pushed corporate profit margin to 7% above historical level of 6%. The higher margin was due to exceptional borrowing and investment by corporations and consumers.
• While the one percent seems to be small, it represents a 17% jump in profitability which is not sustainable.
• Use the historical 6% margin and applying it to an expected rise in corporate revenues as the economy recovers, he finds that the stocks today trade at almost 19 times expected profits, making them expensive.
• To be reasonably priced, he calculates the S&P 500 would have to fall 21% to about 900.

Of course, true value investors will consider guessing the short-term move of the market is a fool’s game. Whether the market will climb 20% or decline 20% next is really everybody’s guess. Guessing the long-term’s performance might be a fool’s game too, if it is up to guys like Warren Buffett, Bruce Berkowitz, and Donald Yacktman to say. For them, one ought to buy a good business on the assumption that no matter how the market will performance in the next couple of years, the business will do well so will the stock follow.

But at least one can answer question of long term expected investment return of the market with a bit more intelligence.

What to Expect in the Next 8 Years?

GuruFocus has developed a webpage dedicated to answer that question. The theory behind (it is actually explained on the webpage itself, I repeat here in case you do not want to click to another page) is that market return consists of three component: dividend yield, profit growth, and change in market valuation. Quoting from the page:

1. Business growth 

If we look at a particular business, the value of the business is determined by how much money this business can make. The growth in the value of the business comes from the growth of the earnings of the business growth. This growth in the business value is reflected as the price appreciation of the company stock if the market recognizes the value, which it does, eventually.

If we look at the overall economy, the growth in the value of the entire stock market comes from the growth of corporate earnings. As we discussed above, over long term, corporate earnings grow as fast as the economy itself.

2. Dividends

Dividend is an important portion of the investment return. Dividend comes from the cash earning of a business. Everything equal, higher dividend payout ratio, in principle, result in a lower growth rate. Therefore, if a company pays out dividend while with growing earnings, the dividend is an additional return for the shareholders besides the appreciation of the business value.

3. Change in the market valuation

Although the value of a business does not change overnight, stock price does. The market valuation is usually measured by the well-known ratios such as P/E, P/S, P/B etc. These ratios can be applied to individual business, as well as the overall market. The ratio Warren Buffett uses for market valuation, TMC/GNP, is equivalent to the P/S ratio of the economy.

Putting all the three factors together, the return of an investment can be estimated by the following formula:






Investment Return (%) = Dividend Yield (%)+ Business Growth (%)+ Change of Valuation (%)

Armed with this analysis and assuming in 8 years, the TMC/GDP ratio takes any one of the 40% (doom’s day scenario), 80% (average scenario), and 120% (happy ending), one can calculate the expected investment return.








As of now, we should expect an average gain of 5.7% for the next 8 years if the market ends the 8-year period at TMC/GDP=80%. Yes, it is mediocre gain as compared to the historical average gain, but it does beat the 10-year treasury yield by about 2%.

Market could sink an average of 2.6% per year if TMC/GD ratio declines to 40%, an extreme level seen in the 1975 to 1985 period. During that period, OPEC was on our case and inflation ran as high as 12%, and long term treasury bonds were yielding at a double digit. Will we go there?

However, if the market participants decides to irrationally exuberant again and TMC/GDP jumps to a 120%, level seen in the 1998-2000 period, we could actually expect a 11.6% gain per annum. What medicine do we need to take in order for us to be so happy again?

So even in long run anything is possible -- if the market goes to the extremes in the next 8 years, the bears like Shiller and Inker could be right, so could be the bullish Jeremy Siegel. Investors are better equipped to know what to expect under each scenario. GuruFocus memebers can access the Broad Market Valuation in real time.

"That's why the value of expertise and the ability to interpret information will someday go to infinity", so says Investment Guru Wilbur Ross recently. 

http://www.gurufocus.com/news.php?id=87078

Over the long term, shares have proved both less risky and more lucrative than other main forms of investments

Shares less risky in long term

Shares are generally thought of as far more risky than investing in bonds or putting money into a bank account. In many ways they are not.

It is true that if someone puts their life savings into the shares of one or two companies in the expectation of a rapid return they are taking a big risk. If they are lucky they could make a substantial gain but they could equally make large losses.

But there are two main ways in which investment in shares can be made less risky.

• One is to diversify from one or two firms to a mixed basket of different types of shares – this is discussed elsewhere on this site (see Advantages of fund investment).
• The other is to extend the duration of the investment to a longer time span.

The longer an investor’s time horizon the safer it is to invest in shares. For long term investment it is actually safer to invest in shares than in bonds or cash.

One definitive study of this phenomenon is by Jeremy Siegel, a professor of finance at the University of Pennsylvania, in Stocks for the Long Run (McGraw-Hill 2002). From a study of American stockmarket returns from 1802-2001 he shows that shares beat bonds and bills (short term government debt)

• 80% of the time with a 10-year horizon,
• 90% of the time with a 20-year horizon and
• almost all the time with a 30-year horizon.

Article ridiculed

Historically this has meant that even if someone has started to invest in shares at the worst time possible they have generally made good returns in the long term. Indeed Professor Siegel starts his book with a discussion of an article published in the summer of 1929 – just before the Wall Street crash - which argued for regular stockmarket investment. The article was subsequently ridiculed as it was published just before a three-year fall in the market which led to a cumulative decline of 89%. But Professor Siegel estimates that even taking this decline into account an investor who had invested in shares regularly for 30 years from 1929 would have made an average annual return of 13%.

Although Professor Siegel’s study concentrates on America the British market has behaved in a similar way. Over the long term shares have easily outperformed other asset classes.

Perhaps the most definitive study of long-term investment trends in relation to the British market is Triumph of the Optimists (Princeton University Press 2002) – the title itself is based on the fact that shares have outperformed other assets in the long term.

• According to this study an investment of £1 in shares in 1900 would have grown to £16,160 in nominal terms by the end of December 2000.
• In contrast the figure for long-term bonds was just £203 and
• for short term Treasury bills only £149.

Of course once inflation is taken into account the increases are not quite so dramatic. Once the 55-fold increase in prices over the century is incorporated into the calculations the return on

• shares would have been 291 times in real terms,
• on bonds 3.7 and
• on bills 2.7.

Inflation risk

Indeed one advantage of shares over bonds is that they tend to perform much better in periods of high inflation.

• Whereas inflation tends to quickly erode the capital value of bonds the stockmarket generally at least keeps up with rising prices.
• In other words one way in which shares are less risky than bonds is their relative immunity to the risk of inflation.

Another factor that can affect relative returns is taxation.

• For instance, if a government decided to impose a punitive tax on share dividends it would clearly hit returns.
• But historically companies have often found ways round this problem – such as distributing income by buying back their own shares – and all the main political parties now support wider share ownership.

As with all forms of investment the past is not necessarily a guide to the future. Returns in the next two decades may not be nearly as great as during the great bull market of 1982-99.

However, historically there is no doubt that over the long term shares have proved both

• less risky and
• more lucrative

than the other main forms of investment.

http://www.morningstar.co.uk/uk/default.aspx?lang=en-GB

 

The Stock Expert Who's Saying "Buy"

The Stock Expert Who's Saying "Buy"
By Selena Maranjian
June 18, 2009





Jeremy Siegel, business professor at the Wharton Business School, has given us investors a lot to learn from. He's the author, for example, of Stocks for the Long Run, and also of The Future for Investors. He's also shown us how to find great stocks and demonstrated the power of dividends.

So when he speaks, we should at least listen, right? Well, he was recently interviewed on public radio, and he advocated investing in stocks for the long haul. "In March,” he said, “we were down more than 50%. And I looked all the way back [over the] last hundred years. Once you're down 50%, your prospects are very good." That's from a guy who has spent a big part of his life studying the stock market's performance over the past 200 years.

Indeed, many well-known stocks are down 50% or more over the past 12 months:

Company
52-Week Return

Alcoa (NYSE: AA)
(72%)

MEMC Electronic Materials (NYSE: WFR)
(71%)

Valero Energy (NYSE: VLO)
(60%)

Chesapeake Energy (NYSE: CHK)
(66%)

Mosaic (NYSE: MOS)
(71%)

Caterpillar (NYSE: CAT)
(55%)

Freeport-McMoRan Copper & Gold (NYSE: FCX)
(58%)


Source: Yahoo! Finance.


One objection I have to Siegel's argument, though, is that it depends entirely on past experience projecting into the future. Think back 100 years to 1909. I know there's much to be learned from the past, but I still worry that we sometimes draw too many parallels. After all, the world was very different then. Our workforce looked different. Our industries were different. Global trade patterns were very different. Business and securities regulation was very different.

He's probably right, though
Nevertheless, I'm not betting against him. Previous bear markets have happened for a variety of different reasons, yet they've all been followed by recoveries. Sure, there's a chance that this time will be the exception. But those who've believed that in the past have gotten burned every time.

As I look at my portfolio, many of my stocks are also down substantially, and I certainly think they're more likely to recover than they are to lose more value over the long run. That's not to say that those share prices won't drop tomorrow, or even over the next year. But over the coming years, I believe these current prices will look like a bargain -- and anyone buying at current levels will be glad they did.



http://www.fool.com/investing/value/2009/06/18/the-stock-expert-whos-saying-buy.aspx





Learn more:
The Best Opportunity in 35 Years
An Opportunity to Jump On
The Next Incredible Buying Opportunity
How to find great stocks
The power of dividends.