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

Defining Value Investing in ONE sentence

Value investing consists of analyzing businesses within one's circle of competence to find those whose return on incremental capital is high, compared to what capital costs, and then investing in those that can be bought most cheaply.  

Growth or the lack of it, is integral to a valuation exercise

The value of a business, a share of stock or any other productive asset is the present value of its future cash flows.

However, value is easier to define than to measure (easier said than done).

Valuing a business (or any productive asset) requires estimating its future performance and discounting the results to present value.  The probable future performance includes whatever GROWTH (or SHRINKAGE) is ASSUMED.

SO GROWTH (OR LACK OF IT) IS INTEGRAL TO A VALUATION EXERCISE.

This supports the point that the phrase value investing is redundant.  Investing is the deliberate determination that one pays a price lower than the value being obtained.  Only speculators pay a price hoping that through growth the value  rises above it.

Growth doesn't equate directly with value either.  

Growing earnings can mean growing value.  But growing earnings can also mean growing expenses, and sometimes expenses growing faster than revenues.  Growth adds value only when the payoff from growth is greater than the cost of growth.

A company reinvesting a dollar of earnings to grow by 99 cents is not helping its shareholders and is not a value stock, though it may be a growth stock.

Value investing is conventionally defined as buying companies bearing low ratios of price-to-earnings, price-to-book value, or high dividend yields.  But these metrics do not by themselves make a company a value investment.  It isn't that simple.  Nor does the absence of such metrics prevent an investment from bearing a sufficient margin of safety and qualitative virtues to justify its inclusion in a value investor's portfolio.

So how would you value the REIT's business?

1. Book Value
The book value or net asset may not also fully value the REIT as a business operating to maximise the stream of rental and other forms of income derived from the property.  So one should not entirely simply rely on the book value.  Value investors however often would be reluctant to pay for a REIT at a price higher than the NAV unless there is immediate prospect of the NAV being re-valued# once a new valuation is conducted.

Book Value = Value of each of the properties + Value of its other assets (cash, inventory and receivables) - Liabilities

2. Property Yield
The property yield shows the earning power of the properties within each of the REIT's portfolio.

Property Yield = Net Property Income / Property valuation x 100

3. Distribution Yield
Distribution yield gives an indication of how much return you would expect from the REIT on an annual basis from the distribution.

Distribution Yield = Distribution per Unit / Price paid for Unit  x 100.


[#The REIT owns the various properties which would be valued by professional valuers at least once annually. Valuers will often provide a value of each property on the basis that the REIT is a going concern i.e. that the business of the REIT is functioning normally and is not forced by distress to sell the property.]


APPROACH TO REIT VALUATION

Why would you want to invest in a REIT?
You want to accumulate a string of properties with your money and allow them to be managed by a professional manager.

What would you want from your portfolio of properties?
1.  You want to enjoy capital appreciation from the property.  You can achieve this easily by owning the properties.
2.  You want the revenue that the properties might generate.  This revenue is necessary to pay all the property expenses including the mortgage and also to provide for you some return to compensate you for the use of your capital that you have ploughed into the properties. For this, you have to calculate the Property Yield and the Distribution Yield.

What further information do you need to make an intelligent decision?
The Distribution Yield tells you your return if the tenants continue to occupy the premises and pay their rent and rental rates stay the same.
1.  What happens if this happy scenario is affected by economic turmoil?
2.  If the property vacancy increases or rental rates drop, can the mortgage still be serviced by the earnings?

Be rational, stay focus on the business of the company and not its share price

What Kills the Amateurs

Nothing is more fatal to amateur investors than thinking that a stock trading near a 52-week low is a good buy. They based this logic on the notion "what goes down must eventually comes up".

Suppose we have 2 companies
i. Co. A had recently gone down from $5 to $1. 
ii Co. B had recently gone up from $1 to $5.

Believe it or not, all things being equal, a majority of amateur investors will choose Co.A because they believe that it will eventually make it back up to those levels again. On the other hand amateur investors will think that chasing after Co.B is almost suicidal because the music will end soon. 

The point is that the stock price is a reflection of the company. If a great firm is run by excellent managers, there is no reason the stock won't keep on going up, vice versa.

Therefore dun said the falling knives killed you when actually you have performed hara-kiri yourselves.


Ref:
http://www.investlah.com/forum/index.php/topic,49773.msg972601.html#msg972601

Berkshire Hathaway's Shareholdings

No.	Shareholder Name	Share Held	Shares Held (%)	Company Name	Exchange
1	Berkshire Hathaway Inc.	0	0	Bank of America Corporation	NYSE
2	Berkshire Hathaway Inc.	1,740,231	0.76	Gannett Co., Inc.	NYSE
3	Berkshire Hathaway Inc.	37,275,400	6.67	DIRECTV	NasdaqGS
4	Berkshire Hathaway Inc.	7,052,750	0.4	Mondelez International, Inc.	NasdaqGS
5	Berkshire Hathaway Inc.	7,484,300	1.75	National Oilwell Varco, Inc.	NYSE
6	Berkshire Hathaway Inc.	52,793,078	1.93	Procter & Gamble Co.	NYSE
7	Berkshire Hathaway Inc.	49,247,235	1.5	Wal-Mart Stores Inc.	NYSE
8	Berkshire Hathaway Inc.	18,939,115	1.63	The Bank of New York Mellon Corporation	NYSE
9	Berkshire Hathaway Inc.	68,121,984	6.14	International Business Machines Corporation	NYSE
10	Berkshire Hathaway Inc.	1,563,434	0.93	Verisk Analytics, Inc.	NasdaqGS
11	Berkshire Hathaway Inc.	400,000,000	8.98	The Coca-Cola Company	NYSE
12	Berkshire Hathaway Inc.	24,922,178	11.18	Moody's Corp.	NYSE
13	Berkshire Hathaway Inc.	588,900	0.01	General Electric Company	NYSE
14	Berkshire Hathaway Inc.	327,100	0.01	Johnson & Johnson	NYSE
15	Berkshire Hathaway Inc.	59,400	0.01	United Parcel Service, Inc.	NYSE
16	Berkshire Hathaway Inc.	14,973,906	14.15	DaVita HealthCare Partners Inc.	NYSE
17	Berkshire Hathaway Inc.	17,072,192	15.73	USG Corporation	NYSE
18	Berkshire Hathaway Inc.	8,174,100	5.42	VeriSign, Inc.	NasdaqGS
19	Berkshire Hathaway Inc.	5,956,600	0.9	Archer Daniels Midland Company	NYSE
20	Berkshire Hathaway Inc.	1,727,765	23.28	The Washington Post Company	NYSE

No.	Shareholder Name	Share Held	Shares Held (%)	Company Name	Exchange
21	Berkshire Hathaway Inc.	151,610,700	13.8	American Express Company	NYSE
22	Berkshire Hathaway Inc.	4,333,363	0.99	Costco Wholesale Corporation	NasdaqGS
23	Berkshire Hathaway Inc.	405,000	0.33	Mastercard Incorporated	NYSE
24	Berkshire Hathaway Inc.	0	0	The Goldman Sachs Group, Inc.	NYSE
25	Berkshire Hathaway Inc.	3,978,767	1.03	Deere & Company	NYSE
26	Berkshire Hathaway Inc.	3,877,122	1.1	General Dynamics Corp.	NYSE
27	Berkshire Hathaway Inc.	5,622,340	null	Liberty Capital Group	NasdaqGS
28	Berkshire Hathaway Inc.	88,863	0.17	Lee Enterprises, Incorporated	NYSE
29	Berkshire Hathaway Inc.	4,646,220	16.68	Media General, Inc.	NYSE
30	Berkshire Hathaway Inc.	484,722,523	9.15	Wells Fargo & Company	NYSE
31	Berkshire Hathaway Inc.	24,123,911	1.97	ConocoPhillips	NYSE
32	Berkshire Hathaway Inc.	1,977,336	1.35	Precision Castparts Corp.	NYSE
33	Berkshire Hathaway Inc.	61,458,101	3.32	U.S. Bancorp	NYSE
34	Berkshire Hathaway Inc.	4,235,818	4.58	Torchmark Corporation	NYSE
35	Berkshire Hathaway Inc.	1,555,459	0.24	Visa Inc.	NYSE
36	Berkshire Hathaway Inc.	7,607,200	1.57	Viacom, Inc.	NasdaqGS
37	Berkshire Hathaway Inc.	5,382,040	4.17	M&T Bank Corporation	NYSE
38	Berkshire Hathaway Inc.	4,076,325	6.53	WABCO Holdings Inc.	NYSE
39	Berkshire Hathaway Inc.	25,000,000	1.82	General Motors Company	NYSE
40	Berkshire Hathaway Inc.	5,622,340	4.67	Liberty Media Corporation	NasdaqGS

No.	Shareholder Name	Share Held	Shares Held (%)	Company Name	Exchange
41	Berkshire Hathaway Inc.	27,163,918	4.39	Phillips 66	NYSE
42	Berkshire Hathaway Inc.	1,602,061	0.27	Kraft Foods Group, Inc.	NasdaqGS
43	Berkshire Hathaway Inc.	6,508,600	6.08	Chicago Bridge & Iron Company N.V.	NYSE
44	Berkshire Hathaway Inc.	5,622,340	4.65	Starz	NasdaqGS

5 Popular Portfolio Types

Stock investors constantly hear the wisdom of diversification. The concept is to simply not put all of your eggs in one basket, which in turn helps mitigate risk, and generally leads to better performance or return on investment. Diversifying your hard-earned dollars does make sense, but there are different ways of diversifying, and there are different portfolio types. We look at the following portfolio types and suggest how to get started building them: aggressive, defensive, income, speculative and hybrid. It is important to understand that building a portfolio will require research and some effort. Having said that, let's have a peek across our five portfolios to gain a better understanding of each and get you started.

The Aggressive PortfolioAn aggressive portfolio or basket of stocks includes those stocks with high risk/high reward proposition. Stocks in the category typically have a high beta, or sensitivity to the overall market. Higher beta stocks experience larger fluctuations relative to the overall market on a consistent basis. If your individual stock has a beta of 2.0, it will typically move twice as much in either direction to the overall market - hence, the high-risk, high-reward description.

Most aggressive stocks (and therefore companies) are in the early stages of growth, and have a unique value proposition. Building an aggressive portfolio requires an investor who is willing to seek out such companies, because most of these names, with a few exceptions, are not going to be common household companies. Look online for companies with earnings growth that is rapidly accelerating, and have not been discovered by Wall Street. The most common sectors to scrutinize would be technology, but many other firms in various sectors that are pursuing an aggressive growth strategy can be considered. As you might have gathered, risk management becomes very important when building and maintaining an aggressive portfolio. Keeping losses to a minimum and taking profit are keys to success in this type of portfolio.

The Defensive PortfolioDefensive stocks do not usually carry a high beta, and usually are fairly isolated from broad market movements. Cyclical stocks, on the other hand, are those that are most sensitive to the underlying economic "business cycle." For example, during recessionary times, companies that make the "basics" tend to do better than those that are focused on fads or luxuries. Despite how bad the economy is, companies that make products essential to everyday life will survive. Think of the essentials in your everyday life, and then find the companies that make these consumer staple products.

The opportunity of buying cyclical stocks is that they offer an extra level of protection against detrimental events. Just listen to the business stations and you will hear portfolios managers talking about "drugs," "defense" and "tobacco." These really are just baskets of stocks that these managers are recommending based upon where the business cycle is and where they think it is going. However, the products and services of these companies are in constant demand. A defensive portfolio is prudent for most investors. A lot of these companies offer a dividend as well which helps minimize downside capital losses.

The Income Portfolio An income portfolio focuses on making money through dividends or other types of distributions to stakeholders. These companies are somewhat like the safe defensive stocks but should offer higher yields. An income portfolio should generate positive cash flow. Real estate investment trusts (REITs) and master limited partnerships (MLP) are excellent sources of income producing investments. These companies return a great majority of their profits back to shareholders in exchange for favorable tax status. REITs are an easy way to invest in real estate without the hassles of owning real property. Keep in mind, however, that these stocks are also subject to the economic climate. REITs are groups of stocks that take a beating during an economic downturn, as building and buying activity dries up.

An income portfolio is a nice complement to most people's paycheck or other retirement income. Investors should be on the lookout for stocks that have fallen out of favor and have still maintained a high dividend policy. These are the companies that can not only supplement income but also provide capital gains. Utilities and other slow growth industries are an ideal place to start your search.

SEE: Dividends Still Look Good After All These Years

The Speculative Portfolio A speculative portfolio is the closest to a pure gamble. A speculative portfolio presents more risk than any others discussed here. Finance gurus suggest that a maximum of 10% of one's investable assets be used to fund a speculative portfolio. Speculative "plays" could be initial public offerings (IPOs) or stocks that are rumored to be takeover targets. Technology or health care firms that are in the process of researching a breakthrough product, or a junior oil company which is about to release its initial production results, would also fall into this category.

Another classic speculative play is to make an investment decision based upon a rumor that the company is subject to a takeover. One could argue that the widespread popularity of leveraged ETFs in today's markets represent speculation. Again, these types of investments are alluring: picking the right one could lead to huge profits in a short amount of time. Speculation may be the one portfolio that, if done correctly, requires the most homework. Speculative stocks are typically trades, and not your classic "buy and hold" investment. 

The Hybrid PortfolioBuilding a hybrid type of portfolio means venturing into other investments, such as bonds, commodities, real estate and even art. Basically, there is a lot of flexibility in the hybrid portfolio approach. Traditionally, this type of portfolio would contain blue chip stocks and some high grade government or corporate bonds. REITs and MLPs may also be an investable theme for the balanced portfolio. A common fixed income investment strategy approach advocates buying bonds with various maturity dates, and is essentially a diversification approach within the bond asset class itself. Basically, a hybrid portfolio would include a mix of stocks and bonds in a relatively fixed allocation proportions. This type of approach offers diversification benefits across multiple asset classes as equities and fixed income securities tend to have a negative correlation with one another. 

The Bottom LineAt the end of the day, investors should consider all of these portfolios and decide on the right allocation across all five. Here, we have laid the foundation by defining five of the more common types of portfolios. Building an investment portfolio does require more effort than a passive, index investing approach. By going it alone, you will be required to monitor your portfolio(s) and rebalance more frequently, thus racking up commission fees. Too much or too little exposure to any portfolio type introduces additional risks. Despite the extra required effort, defining and building a portfolio will increase your investing confidence, and give you control over your finances.

SEE: How To Pick A Stock

January 26 2013

http://www.investopedia.com/articles/basics/11/5-popular-portfolio-types.asp

Warren Buffett's Bear Market Maneuvers

In times of economic decline, many investors ask themselves, "What strategies does the Oracle of Omaha employ to keep Berkshire Hathaway on target?" The answer is that the esteemed Warren Buffett, the most successful known investor of all time, rarely changes his long-term value investment strategy and regards down markets as an opportunity to buy good companies at reasonable prices. In this article, we will cover the Buffett investment philosophy and stock-selection criteria with specific emphasis on their application in a down market and a slowing economy. (For more on Warren Buffett and his current holdings, sign up for our Coattail Investor newsletter.)

The Buffett Investment PhilosophyBuffett has a set of definitive assumptions about what constitutes a "good investment". These focus on the quality of the business rather than the short-term or near-future share price or market moves. He takes a long-term, large scale, business value-based investment approach that concentrates on good fundamentals and intrinsic business value, rather than the share price. (For further reading, see Warren Buffett: The Road To Riches and What Is Warren Buffett's Investing Style?)

Buffett looks for businesses with "a durable competitive advantage." What he means by this is that the company has a market position, market share, branding or other long-lasting edge over its competitors that either prevents easy access by competitors or controls a scarce raw-material source. (For more insight, see Competitive Advantage Counts, 3 Secrets Of Successful Companiesand Economic Moats Keep Competitors At Bay.)

Buffett employs a selective contrarian investment strategy: using his investment criteria to identify and select good companies, he can then make large investments (millions of shares) when the market and the share price are depressed and when other investors may be selling.

In addition, he assumes the following points to be true:

• The global economy is complex and unpredictable.
• The economy and the stock market do not move in sync.
• The market discount mechanism moves instantly to incorporate news into the share price.
• The returns of long-term equities cannot be matched anywhere else.

Buffett Investment ActivityBerkshire Hathaway investment industries over the years have included:

• Insurance 
• Soft drinks 
• Private jet aircraft
• Chocolates 
• Shoes
• Jewelry 
• Publishing
• Furniture 
• Steel
• Energy 
• Home building

The industries listed above vary widely, so what are the common criteria used to separate the good investments from the bad?

Buffett Investment Criteria

Berkshire Hathaway relies on an extensive research-and-analysis team that goes through reams of data to guide their investment decisions. While all the details of the specific techniques used are not made public, the following 10 requirements are all common among Berkshire Hathaway investments:

1. The candidate company has to be in a good and growing economy or industry.
2. It must enjoy a consumer monopoly or have a loyalty-commanding brand.
3. It cannot be vulnerable to competition from anyone with abundant resources.
4. Its earnings have to be on an upward trend with good and consistent profit margins.
5. The company must enjoy a low debt/equity ratio or a high earnings/debt ratio.
6. It must have high and consistent returns on invested capital.
7. The company must have a history of retaining earnings for growth.
8. It cannot have high maintenance costs of operations, high capital expenditure or investment cash flow.
9. The company must demonstrate a history of reinvesting earnings in good business opportunities, and its management needs a good track record of profiting from these investments.
10. The company must be free to adjust prices for inflation.

The Buffett Investment StrategyBuffett makes concentrated purchases. In a downturn, he buys millions of shares of solid businesses at reasonable prices. Buffett does not buy tech shares because he doesn't understand their business or industry; during the dotcom boom, he avoided investing in tech companies because he felt they hadn't been around long enough to provide sufficient performance history for his purposes.

And even in a bear market, although Buffett had billions of dollars in cash to make investments, in his 2009 letter to Berkshire Hathaway shareholders, he declared that cash held beyond the bottom would be eroded by inflation in the recovery.

Buffett deals only with large companies because he needs to make massive investments to garner the returns required to post excellent results for the huge size to which his company, Berkshire Hathaway, has grown. (To learn about the disadvantage of being confined to blue chip stocks, readWhy Warren Buffett Envies You.)

Buffett's selective contrarian style in a bear market includes making some large investments in blue chip stocks when their stock price is very low. And Buffett might get an even better deal than the average investor: His ability to supply billions of dollars in cash infusion investments earns him special conditions and opportunities not available to others. His investments often are in a class of secured stock with its dividends assured and future stock warrants available at below-market prices.

ConclusionBuffett's strategy for coping with a down market is to approach it as an opportunity to buy good companies at reasonable prices. Buffett has developed an investment model that has worked for him and the Berkshire Hathaway shareholders over a long period of time. His investment strategy is long term and selective, incorporating a stringent set of requirements prior to an investment decision being made. Buffett also benefits from a huge cash "war chest" that can be used to buy millions of shares at a time, providing an ever-ready opportunity to earn huge returns.

For further reading, see Think Like Warren Buffett and Warren Buffett's Best Buys.

July 12 2009

http://www.investopedia.com/articles/stocks/09/buffett-bear-market-strategies.asp?utm_source=coattail-buffett&utm_medium=Email&utm_campaign=WBW-6/12/2013-b

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