How To Evaluate The Quality Of EPS

by Rick Wayman 

Earning per share (EPS) manipulation might be the second oldest profession, but there is a relatively easy way for investors to protect themselves. This article will show you how to evaluate the quality of any kind of EPS, and find out what it's telling you about a stock.

Tutorial: Examining Earnings Quality
Overview
The evaluation of earnings per share should be a relatively straightforward process, but thanks to the magic of accounting, it has become a game of smoke and mirrors, accompanied by constantly mutating versions that seem to have come out of "Alice in Wonderland". Instead of Tweedle-Dee and Tweedle-Dum we have pro forma EPS and EBITDA. And, despite rumors to the contrary, the whisper number - the Cheshire cat of Wall Street - continues to exist as guidance.

To be fair, this situation cannot be totally blamed on management. Wall Street deserves as much blame due to its myopic focus on the near-term and knee-jerk reactions to 1 cent misses. A forecast is always only a guess - nothing more, nothing less - but Wall Street often forgets this. This, however, does create opportunities for investors who can evaluate the quality of earnings over the long run and take advantage of market overreactions. (For background reading, check out Earnings Forecasts: A Primer.)


EPS Quality

High-quality EPS means that the number is a relatively true representation of what the company actually earned (i.e. cash generated).  But while evaluating EPS cuts through a lot of the accounting gimmicks, it does not totally eliminate the risk that the financial statements are misrepresented. While it is becoming harder to manipulate the statement of cash flows, it can still be done.

A low-quality EPS number does not accurately portray what the company earned. GAAP EPS (earnings reported according to Generally Accepted Accounting Principles) may meet the letter of the law but may not truly reflect the earnings of the company. Sometimes GAAP requirements may be to blame for this discrepancy; other times it is due to choices made by management. In either case, a reported number that does not portray the real earnings of the company can mislead investors into making bad investment decisions. 

How to Evaluate the Quality of EPS

The best way to evaluate quality is to compare operating cash flow per share to reported EPS. While this is an easy calculation to make, the required information is often not provided until months after results are announced, when the company files its 10-K or 10-Q with theSEC.

To determine earnings quality, investors can rely on operating cash flow. The company can show a positive earnings on the income statement while also bearing a negative cash flow. This is not a good situation to be in for a long time, because it means that the company has to borrow money to keep operating. And at some point, the bank will stop lending and want to be repaid. A negative cash flow also indicates that there is a fundamental operating problem: either inventory is not selling or receivables are not getting collected. "Cash is king" is one of the few real truisms on Wall Street, and companies that don't generate cash are not around for long. Want proof? Just look at how many of the dotcom wonders survived! (To learn more about what happened, see Why did dotcom companies crash so drastically?)

If operating cash flow per share (operating cash flow divided by the number of shares used to calculate EPS) is greater than reported EPS, earnings are of a high quality because the company is generating more cash than is reported on the income statement. Reported (GAAP) earnings, therefore, understate the profitability of the company.

If operating cash flow per share is less than reported EPS, it means that the company is generating less cash than is represented by reported EPS. In this case, EPS is of low quality because it does not reflect the negative operating results of the company and overstates what the true (cash) operating results. 

Watch: Earning Per Share

An Example
Let's say that Behemoth Software (BS for short) reported that its GAAP EPS was $1. Assume that this number was derived by following GAAP and that management did not fudge its books. And assume further that this number indicates an impressive growth rate of 20%. In most markets, investors would buy this stock.

However, if BS's operating cash flow per share were a negative 50 cents, it would indicate that the company really lost 50 cents of cash per share versus the reported $1. This means that there was a gap of $1.50 between the GAAP EPS and actual cash per share generated by operations. A red flag should alert investors that they need to do more research to determine the cause and duration of the shortfall. The 50 cent negative cash flow per share would have to be financed in some way, such as borrowing from a bank, issuing stock, or selling assets. These activities would be reflected in another section of the cash flow statement.

If BS's operating cash flow per share were $1.50, this would indicate that reported EPS was of high quality because actual cash that BS generated was 50 cents more than was reported under GAAP. A company that can consistently generate growing operating cash flows that are greater than GAAP earnings may be a rarity, but it is generally a very good investment. (To learn more about this metric, check out Operating Cash Flow: Better Than Net Income?)

Trends Are Also Important

Because a negative cash flow may not necessarily be illegitimate, investors should analyze the trend of both reported EPS and operating cash flow per share (or net income and operating cash flow) in relation to industry trends. It is possible that an entire industry may generate negative operating cash flow due to cyclical causes. Operating cash flows may be negative also because of the company's need to invest in marketing, information systems and R&D. In these cases, the company is sacrificing near-term profitability for longer-term growth.

Evaluating trends will also help you spot the worst-case scenario, which occurs when a company reports increasingly negative operating cash flow and increasing GAAP EPS. As discussed above, there may be legitimate reasons for this discrepancy (economic cycles, the need to invest for future growth), but if the company is to survive, the discrepancy cannot last long. The appearance of growing GAAP EPS even though the company is actually losing money can mislead investors. This is why investors should evaluate the legitimacy of a growing GAAP by analyzing the trend in debt levels, times interest earned, days sales outstanding and inventory turnover. (To learn about why companies fudge cash flow, readCash Flow On Steroids: Why Companies Cheat.)

The Bottom Line

Without question, cash is king on Wall Street, and companies that generate a growing stream of operating cash flow per share are better investments than companies that post increased GAAP EPS growth and negative operating cash flow per share. The ideal situation occurs when operating cash flow per share exceeds GAAP EPS. The worst situation occurs when a company is constantly using cash (causing a negative operating cash flow) while showing positive GAAP EPS. Luckily, it is relatively easy for investors to evaluate the situation. 

by Rick Wayman (Contact Author | Biography)

Filed Under: Accounting, Fundamental Analysis, Stock Analysis, Stocks

http://www.investopedia.com/articles/analyst/03/091703.asp

ROA And ROE Give Clear Picture Of Corporate Health

by Ben McClure 

With all the ratios that investors toss around, it's easy to get confused. Consider return on equity (ROE) and return on assets (ROA). Because they both measure a kind of return, at first glance, these two metrics seem pretty similar. Both gauge a company's ability to generate earnings from its investments. But they don't exactly represent the same thing. A closer look at these two ratios reveals some key differences. Together, however, they provide a clearer representation of a company's performance. Here we look at each ratio and what separates them.

ROE
Of all the fundamental ratios that investors look at, one of the most important is return on equity. It's a basic test of how effectively a company's management uses investors' money - ROE shows whether management is growing the company's value at an acceptable rate. ROE is calculated as:

Annual Net Income             Average Shareholders' Equity

You can find net income on the income statement, and shareholders' equity appears at the bottom of the company's balance sheet.

Let's calculate ROE for the fictional company Ed's Carpets. Ed's 2009 income statement puts its net income at $3.822 billion. On the balance sheet, you'll find total stockholder equity for 209 was $25.268 billion; in 2008 it was $6.814 billion.

To calculate ROE, average shareholders' equity for 2009 and 2008 ($25.268bn + $6.814bn / 2 = $16.041 bn), and divide net income for 2009 ($3.822 billion) by that average. You will arrive at a return on equity of 0.23, or 23%. This tells us that in 2009 Ed's Carpets generated a 23% profit on every dollar invested by shareholders.

Many professional investors look for a ROE of at least 15%. So, by this standard alone, Ed's Carpets' ability to squeeze profits from shareholders' money appears rather impressive. (For further reading, see Keep Your Eyes On The ROE.)

ROA
Now, let's turn to return on assets, which, offering a different take on management's effectiveness, reveals how much profit a company earns for every dollar of its assets. Assets include things like cash in the bank, accounts receivable, property, equipment, inventory and furniture. ROA is calculated like this:

Annual Net Income             Total Assets

Let's look at Ed's again. You already know that it earned $3.822 billion in 2009, and you can find total assets on the balance sheet. In 2009, Ed's Carpets' total assets amounted to $448.507 billion. Its net income divided by total assets gives a return on assets of 0.0085, or 0.85%. This tells us that in 2009 Ed's Carpets earned less than 1% profit on the resources it owned.

This is an extremely low number. In other words, this company's ROA tells a very different story about its performance than its ROE. Few professional money managers will consider stocks with an ROA of less than 5%. (For further reading, see ROA On The Way.)

Watch: Reture On Assets

The Difference Is All About Liabilities
The big factor that separates ROE and ROA is financial leverage, or debt. The balance sheet's fundamental equation shows how this is true: assets = liabilities + shareholders' equity. This equation tells us that if a company carries no debt, its shareholders' equity and its total assets will be the same. It follows then that their ROE and ROA would also be the same.

But if that company takes on financial leverage, ROE would rise above ROA. The balance sheet equation - if expressed differently - can help us see the reason for this: shareholders' equity = assets - liabilities. By taking on debt, a company increases its assets thanks to the cash that comes in. But since equity equals assets minus total debt, a company decreases its equity by increasing debt. In other words, when debt increases, equity shrinks, and since equity is the ROE's denominator, ROE, in turn, gets a boost. At the same time, when a company takes on debt, the total assets - the denominator of ROA - increase. So, debt amplifies ROE in relation to ROA.

Ed's balance sheet should reveal why the company's return on equity and return on assets were so different. The carpet-maker carried an enormous amount of debt - which kept its assets high while reducing shareholders' equity. In 2009, it had total liabilities that exceeded $422 billion - more than 16 times its total shareholders' equity of $25.268 billion.

Because ROE weighs net income only against owners' equity, it doesn't say much about how well a company uses its financing from borrowing and bonds. Such a company may deliver an impressive ROE without actually being more effective at using the shareholders' equity to grow the company. ROA - because its denominator includes both debt and equity - can help you see how well a company puts both these forms of financing to use.


Conclusion
So, be sure to look at ROA as well as ROE. They are different, but together they provide a clear picture of management's effectiveness. If ROA is sound and debt levels are reasonable, a strong ROE is a solid signal that managers are doing a good job of generating returns from shareholders' investments. ROE is certainly a “hint” that management is giving shareholders more for their money. On the other hand, if ROA is low or the company is carrying a lot of debt, a high ROE can give investors a false impression about the company's fortunes.

by Ben McClure (Contact Author | Biography)

Ben McClure is a long-time contributor to Investopedia.com.

Ben is the director of Bay of Thermi Limited, an independent research and consulting firm that specializes in preparing early stage ventures for new investment and the marketplace. He works with a wide range of clients in the North America, Europe and Latin America. Ben was a highly-rated European equities analyst at London-based Old Mutual Securities, and led new venture development at a major technology commercialization consulting group in Canada. He started his career as writer/analyst at the Economist Group. Mr. McClure graduated from the University of Alberta's School of Business with an MBA.

Ben's hard and fast investing philosophy is that the herd is always wrong, but heck, if it pays, there's nothing wrong with being a sheep.

He lives in Thessaloniki, Greece. You can learn more about Bay of Thermi Limited atwww.bayofthermi.com.

Filed Under: Accounting, Fundamental Analysis, Investing Basics, Stock Analysis, Stocks

http://www.investopedia.com/articles/basics/05/052005.asp

Redefining Investor Risk

by Troy Adkins 

You have probably been told by many financial advisors that your risk tolerance should be a function of your investment time horizon. This belief is touted by almost everyone in the financial services industry, because it is predominately accepted that if you plan to invest for a long period of time, you can make more risky investments. However, before blindly accepting this theory as factual truth, let's look at four ways in which risk can be defined. After thinking about risk from these four different perspectives, you may reach a different conclusion about investing. (Forget the clichés and uncover how much volatility you can really stand. To learn more, see Personalizing Risk Tolerance.)

Risk Theory No.1: Risk is Reduced if You Have More Time to Recoup Your Losses
Some people believe that if you have a long time horizon, you can take on more risk, because if something goes wrong with your investment, you will have time to recoup your losses. When risk is looked at in this manner, risk does indeed decrease as the time horizon increases. However, if you accept this definition of risk, it is recommended that you keep track of the loss on your investment, as well as the opportunity cost that you gave up by not investing in a risk free security. This is important because you need to know not only how long it will take you to recoup the loss on your investment, but also how long it will take you to recoup the loss associated with not investing in a product that can generate a guaranteed rate of return, such as a government bond.

Risk Theory No.2: A Longer Time Horizon Decreases Risk by Reducing the Standard Deviation of the Investment
You may have also heard that risk decreases as the time horizon increases, because the standard deviation of an investment's compounded average annual return decreases as the time horizon increases, due to mean reversions. This definition of risk is based on two important statistical theories. The first theory is known as the law of large numbers, which states that the likelihood of an investor's actual average return achieving its long run historical average return increases as the time horizon increases – basically, the larger the sample size, the more likely the average results are to occur. The second theory is the central limit theorem of probability theory, which states that as the sample size increases, which in this context means as the time horizon increases, the sampling distribution of sample means approaches that of a normal distribution.

You may have to ponder theses concepts for a period of time before you comprehend their implications about investing. However, the law of large numbers simply implies that the dispersion of returns around an investment's expected return will decrease as the time horizon increases. If this concept is true, then risk must also decrease as the time horizon increases, because in this case, dispersion, measured by variation around the mean, is the measure of risk. Moving one step further, the practical implications of the central limit theorem of probability theory stipulates that if an investment has a standard deviation of 20% for the one-year period, its volatility would be reduced to its expected value as time increases. As you can see from these examples, when the law of large numbers and the central limit theorem of probability theory are taken into account, risk, as measured by standard deviation, does indeed appear to decrease as the time horizon is lengthened.

Unfortunately, the application of these theories is not directly applicable in the investment world, because the law of large number requires too many years of investing before the theory would have any real world implications. Moreover, the central limit theorem of probability theory does not apply in this context because empirical evidence shows that a constant standard deviation is an inaccurate measure of investment risk, due to the fact that investment performance, is typically skewed and exhibits kurtosis. This in turn means that investment performance is not normally distributed, which in turn nullifies the central limit theorem of probability theory. In addition, investment performance is typically subject to heteroskedasticity, which in turn greatly hinders the usefulness of using standard deviation as a measure risk. Given these problems, one should not postulate that risk is reduced by time, at least not based on the premise of these two theories. (For more information on how statistics can help you invest, check out Stock Market Risk: Wagging The Tails.)

An additional problem occurs when investment risk is measured using standard deviation, as it is based on the position that you will make a one-time investment and hold that exact investment over the length of the time horizon. Given that most investors employ dollar-cost averaging strategies that entail ongoing periodic investment contributions, the theories do not apply. This is because every time a new investment contribution is made, that portion is subject to another standard deviation than the rest of that investment. In addition, most investors tend to use investment products such as mutual funds, and these types of products constantly change their underlying securities over time. As a result, the underlying concepts associated with these theories do not apply when investing.

Risk Theory No.3: Risk Increases as the Time Horizon Increases
If you define risk as the probability of having an ending value that is close to what you expect to have at a certain point in time, then risk actually does increase as the time horizon increases. This phenomenon is attributed to the fact that the magnitude of potential losses increases as the time horizon increases, and this relationship is properly captured when measuring risk by using continuously compounded total returns. Since most investors are concerned about the probability of having a certain amount of money at a certain period of time, given a specific portfolio allocation, it seems logical to measure risk in this manner.

Based on Monte Carlo simulation observational analysis, a greater dispersion in potential portfolio outcomes manifests itself as both the probability up and down movements built into the simulation increase, and as the time horizon lengthens. Monte Carlo simulation will generate this outcome because financial market returns are uncertain, and therefore the range of returns on either side of the median projected return can be magnified due to compounding multi year effects. Furthermore, a number of good years can quickly be wiped out by a bad year.

Risk Theory No.4: The Relationship Between Risk and Time from the Standpoint of Common Sense
Moving away from academic theory, common sense would suggest that the risk of any investment increases as the length of the time horizon increases simply because future events are hard to forecast. To prove this point, you can look at the list of companies that made up the Dow Jones Industrial Average back when it was formed in 1896. What you will find is that only one company that was part of the index in 1896 is still a component of the index today. That company is General Electric. The other companies have been bought out, broken up by the government, removed by the Dow Jones Index Committee or have gone out of business.

More current examples that support this empirical position are the recent demise of Lehman Brothers and Bear Sterns. Both of these companies were well established Wall Street banks, yet their operational and business risks ultimately led them into bankruptcy. Given these examples, one should surmise that time does not reduce the unsystematic risk associated with investing. (This company survived many financial crises in its long history. Find out what finally drove it to bankruptcy. Read Case Study: The Collapse of Lehman Brothers.)

Moving away from a historical view of the relationship between risk and time to a view that may help you understand the true relationship between risk and time, ask yourself two simple questions: First, "How much do you think an ounce of gold will cost at the end of this year?" Second, "How much do you think an ounce of gold will cost 30 years from now?" It should be obvious that there is much more risk in trying to accurately estimate how much gold will cost in the distant future, because there are a multitude of potential factors that may have a compounded impact on the price of gold over time.

Conclusion
Empirical examples such as these make a strong case that time does not reduce risk. Given this position, investors should reach a very important conclusion when looking at the relationship between risk and time from the standpoint of investing. You cannot reduce your risk by lengthening your time horizon. Therefore, the only way you can mitigate the impact of unsystematic risk, is by developing a broadly diversified portfolio.

by Troy Adkins (Contact Author | Biography)

Mr. Adkins is a senior investment analyst with a global tactical asset management firm. He works and resides in New York City. He has a diverse background and more than 10 years of investment experience.

Filed Under: Investing Basics, Investment

http://www.investopedia.com/articles/trading/10/investors-need-to-know-risk-time.asp

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The interaction between your risks and your time horizon influences every investment decision you make, whether you know it or not. Learn the basics here. Read: Redefining Investor Risk

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Digging Into The Dividend Discount Model

by Ben McClure 

It's time to dust off one of the oldest, most conservative methods of valuing stocks - thedividend discount model (DDM). It's one of the basic applications of a financial theory that students in any introductory finance class must learn. Unfortunately, the theory is the easy part. The model requires loads of assumptions about companies' dividend payments and growth patterns, as well as future interest rates. Difficulties spring up in the search for sensible numbers to fold into the equation. Here we'll examine this model and show you how to calculate it. (Will the dividend discount model work for you? Find out more in How To Choose The Best Stock Valuation Method.)

Tutorial: Top Stock-Picking Strategies

The Dividend Discount Model
Here is the basic idea: any stock is ultimately worth no more than what it will provide investors in current and future dividends. Financial theory says that the value of a stock is worth all of the future cash flows expected to be generated by the firm, discounted by an appropriate risk-adjusted rate. According to the DDM, dividends are the cash flows that are returned to the shareholder. (We're going to assume you understand the concepts of time value of money and discounting. You can learn more about these subjects in Understanding The Time Value Of Money.)

To value a company using the DDM, you calculate the value of dividend payments that you think a stock will throw-off in the years ahead. Here is what the model says:

Where:
P= the price at time 0
r= discount rate

For simplicity's sake, consider a company with a $1 annual dividend. If you figure the company will pay that dividend indefinitely, you must ask yourself what you are willing to pay for that company. Assume expected return, or, more appropriately in academic parlance, therequired rate of return, is 5%. According to the dividend discount model, the company should be worth $20 ($1.00 / .05).

How do we get to the formula above? It's actually just an application of the formula for aperpetuity:



The obvious shortcoming of the model above is that you'd expect most companies to grow over time. If you think this is the case, then the denominator equals the expected return less the dividend growth rate. This is known as the constant growth DDM or the Gordon modelafter its creator, Myron Gordon. Let's say you think the company's dividend will grow by 3% annually. The company's value should then be $1 / (.05 - .03) = $50. Here is the formula for valuing a company with a constantly growing dividend, as well as the proof of the formula:


The classic dividend discount model works best when valuing a mature company that pays a hefty portion of its earnings as dividends, such as a utility company.

The Problem of Forecasting
Proponents of the dividend discount model say that only future cash dividends can give you a reliable estimate of a company's intrinsic value. Buying a stock for any other reason - say, paying 20 times the company's earnings today because somebody will pay 30 times tomorrow - is mere speculation.

In truth, the dividend discount model requires an enormous amount of speculation in trying to forecast future dividends. Even when you apply it to steady, reliable, dividend-paying companies, you still need to make plenty of assumptions about their future. The model is subject to the axiom "garbage in, garbage out", meaning that a model is only as good as the assumptions it is based upon. Furthermore, the inputs that produce valuations are always changing and susceptible to error.

The first big assumption that the DDM makes is that dividends are steady, or grow at a constant rate indefinitely. But even for steady, reliable, utility-type stocks, it can be tricky to forecast exactly what the dividend payment will be next year, never mind a dozen years from now. (Find out some of the reasons why companies cut dividends in Your Dividend Payout: Can You Count On It?)


Multi-Stage Dividend Discount Models 
To get around the problem posed by unsteady dividends, multi-stage models take the DDM a step closer to reality by assuming that the company will experience differing growth phases. Stock analysts build complex forecast models with many phases of differing growth to better reflect real prospects. For example, a multi-stage DDM may predict that a company will have a dividend that grows at 5% for seven years, 3% for the following three years and then at 2% in perpetuity.

However, such an approach brings even more assumptions into the model - although it doesn't assume that a dividend will grow at a constant rate, it must guess when and by how much a dividend will change over time.

What Should Be Expected?
Another sticking point with the DDM is that no one really knows for certain the appropriate expected rate of return to use. It's not always wise simply to use the long-term interest rate because the appropriateness of this can change.

Watch: Dividend Yields

The High-Growth Problem
No fancy DDM model is able to solve the problem of high-growth stocks. If the company's dividend growth rate exceeds the expected return rate, you cannot calculate a value because you get a negative denominator in the formula. Stocks don't have a negative value. Consider a company with a dividend growing at 20% while the expected return rate is only 5%: in the denominator (r-g) you would have -15% (5%-20%)!

In fact, even if the growth rate does not exceed the expected return rate, growth stocks, which don't pay dividends, are even tougher to value using this model. If you hope to value a growth stock with the dividend discount model, your valuation will be based on nothing more than guesses about the company's future profits and dividend policy decisions. Most growth stocks don't pay out dividends. Rather, they re-invest earnings into the company with the hope of providing shareholders with returns by means of a higher share price.

Consider Microsoft, which didn't pay a dividend for decades. Given this fact, the model might suggest the company was worthless at that time - which is completely absurd. Remember, only about one-third of all public companies pay dividends. Furthermore, even companies that do offer payouts are allocating less and less of their earnings to shareholders.

Conclusion
The dividend discount model is by no means the be-all and end-all for valuation. That being said, learning about the dividend discount model does encourage thinking. It forces investors to evaluate different assumptions about growth and future prospects. If nothing else, the DDM demonstrates the underlying principle that a company is worth the sum of its discounted future cash flows. (Whether or not dividends are the correct measure of cash flow is another question.) The challenge is to make the model as applicable to reality as possible, which means using the most reliable assumptions available.

by Ben McClure (Contact Author | Biography)

Ben McClure is a long-time contributor to Investopedia.com.

Ben is the director of Bay of Thermi Limited, an independent research and consulting firm that specializes in preparing early stage ventures for new investment and the marketplace. He works with a wide range of clients in the North America, Europe and Latin America. Ben was a highly-rated European equities analyst at London-based Old Mutual Securities, and led new venture development at a major technology commercialization consulting group in Canada. He started his career as writer/analyst at the Economist Group. Mr. McClure graduated from the University of Alberta's School of Business with an MBA.

Ben's hard and fast investing philosophy is that the herd is always wrong, but heck, if it pays, there's nothing wrong with being a sheep.

He lives in Thessaloniki, Greece. You can learn more about Bay of Thermi Limited atwww.bayofthermi.com.

Filed Under: Dividend, Financial Theory, Fundamental Analysis, Stock Analysis, Stocks

http://www.investopedia.com/articles/fundamental/04/041404.asp

Valuing A Stock With Supernormal Dividend Growth Rates

by Peter Cherewyk 

The supernormal growth model is most commonly seen in finance classes or more advanced investing certificate exams. It is based on discounting cash flows, and the purpose of the supernormal growth model is to value a stock which is expected to have higher than normal growth in dividend payments for some period in the future. After this supernormal growth the dividend is expected to go back to a normal with a constant growth. (For a background reading, check out Digging Into The Dividend Discount Model.)

Tutorial: Discounted Cash Flow Analysis

To understand the supernormal growth model we will go through three steps.

1. Dividend discount model (no growth in dividend payments)

2. Dividend growth model with constant growth (Gordon Growth Model)

3. Dividend discount model with supernormal growth

Dividend Discount Model (No Growth in Dividend Payments)
Preferred equity will usually pay the stockholder a fixed dividend, unlike common shares. If you take this payment and find the present value of the perpetuity you will find the implied value of the stock.

For example, if ABC Company is set to pay a $1.45 dividend next period and the required rate of return is 9%, then the expected value of the stock using this method would be 1.45/0.09 = $16.11. Every dividend payment in the future was discounted back to the present and added together.

V = D1/(1+k) + D2/(1+k)2 + D3/(1+k)3 + ... + Dn/(1+k)n

Where:
V = the value
D₁ = the dividend next period
k = the required rate of return

For example:

V = $1.45/(1.09) + $1.45/(1.09)2 + $1.45/(1.09)3 + … + $1.45/(1.09)n V= $1.33 + 1.22 + 1.12 + . . . V= $16.11

Because every dividend is the same we can reduce this equation down to: V= D/k

V=$1.45/0.09

V=$16.11

With common shares you will not have the predictability in the dividend distribution. To find the value of a common share, take the dividends you expect to receive during your holding period and discount it back to the present period. But there is one additional calculation: when you sell the common shares you will have a lump sum in the future which will have to be discounted back as well. We will use "P" to represent the future price of the shares when you sell them. Take this expected price (P) of the stock at the end of the holding period and discount it back at the discount rate. You can already see that there are more assumptions you need to make which increases the odds of miscalculating. (Explore arguments for and against company dividend policy, and learn how companies determine how much to pay out, read How And Why Do Companies Pay Dividends?)

For example, if you were thinking about holding a stock for three years and expected the price to be $35 after the third year,  the expected dividend is $1.45 per year.

V= D1/(1+k) + D2/(1+k)2  + D3/(1+k)3 + P/(1+k)3 V = $1.45/1.09 + $1.45/1.092 + $1.45/1.093 +$35/1.093

Dividend Growth Model with Constant Growth (Gordon Growth Model)
Next let's assume there is a constant growth in the dividend. This would be best suited for evaluating larger stable dividend paying stocks. Look to the history of consistent dividend payments and predict the growth rate given the economy the industry and the company's policy on retained earnings.

Again we base the value on the present value of future cash flows:

V = D1/(1+k) + D2/(1+k)2+…..+Dn/(1+k)n

But we add a growth rate to each of the dividends (D₁, D₂, D₃, etc.) In this example we will assume a 3% growth rate.

So D₁ would be $1.45(1.03) = $1.49

D₂ = $1.45(1.03)² = $1.54

D₃ = $1.45(1.03)³ = $1.58

This changes our original equation to : 

V = D1(1.03)/(1+k) + D2(1.03)2/(1+k)2+…..+Dn(1.03)n/(1+k)n V = $1.45(1.03)/(1.09) + $1.45(1.03)2/(1.09)2 + $1.45(1.03)3/(1.09)3 + … + $1.45(1.03)n/(1.09)n V = $1.37 +$1.29 + $1.22 + …. V = 24.89

This reduces down to: V = D₁/k-g

Dividend Discount Model with Supernormal Growth
Now that we know how to calculate the value of a stock with a constantly growing dividend we can move on to a supernormal growth dividend.

One way to think about the dividend payments is in two parts (A and B). Part A has a higher growth dividend; Part B has a constant growth dividend. (For more, see How Dividends Work For Investors.)

A) Higher Growth
This part is pretty straight forward - calculate each dividend amount at the higher growth rate and discount it back to the present period. This takes care of the supernormal growth period; all that is left is the value of the dividend payments which will grow at a continuous rate.

B) Regular Growth
Still working with the last period of higher growth, calculate the value of the remaining dividends using the V = D₁/(k-g) equation from the previous section. But D₁ in this case would be next year's dividend, expected to be growing at the constant rate. Now discount back to the present value through four periods. A common mistake is discounting back five periods instead of four. But we use the fourth period because the valuation of the perpetuity of dividends is based on the end of year dividend in period four, which takes into account dividends in year five and on.

The values of all discounted dividend payments are added up to get the net present value. For example if you have a stock which pays a $1.45 dividend which is expected to grow at 15% for three years then at a constant 6% into the future. The discount rate is 12%.

Steps

1. Find the four high growth dividends.

2. Find the value of the constant growth dividends from the fifth dividend onward.

3. Discount each value.

4. Add up the total amount.

Period	Dividend	Calculation	Amount	Present Value
1	D1	$1.45 x 1.151	$1.67	$1.50
2	D2	$1.45 x 1.152	$1.92	$1.56
3	D3	$1.45 x 1.153	$2.21	$1.61
4	D4	$1.45 x 1.154	$2.54	$1.67
5	D5 …	$2.536 x 1.06	$2.69
		$2.688 / (0.11 - 0.06)	$53.76
		$53.76 / 1.114		$35.42
			NPV	$41.76

Implementation
When doing a discount calculation you are usually attempting to estimate the value of the future payments. Then you can compare this calculated intrinsic value to the market price to see if the stock is over or undervalued compared to your calculations. In theory this technique would be used on growth companies expecting higher than normal growth, but the assumptions and expectations are hard to predict. Companies could not maintain a high growth rate over long periods of time. In a competitive market new entrants and alternatives will compete for the same returns thus bringing return on equity (ROE) down.

The Bottom LineCalculations using the supernormal growth model are difficult because of the assumptions involved such as the required rate or return, growth or length of higher returns. If this is off, it could drastically change the value of the shares. In most cases, such as tests or homework, these numbers will be given, but in the real world we are left to calculate and estimate each of the metrics and evaluate the current asking price for shares. Supernormal growth is based on a simple idea but can even give veteran investors trouble. (For more, check out Taking Stock Of Discounted Cash Flow.)

by Peter Cherewyk (Contact Author | Biography)

Peter Cherewyk has worked in the financial field for over 10 years. He completed his Bachelor of Commerce from the University of Alberta, and is currently working towards a Chartered Financial Analyst designation. He enjoys hockey and hiking and the opportunity to teach others.

Filed Under: Dividend, Fundamental Analysis, Stock Analysis, Stocks

http://www.investopedia.com/articles/fundamental-analysis/11/supernormal-growth-analysis.asp

Dutch Lady anticipates rising raw material prices

Spreadsheet of Dutch Lady 27.3.2011
https://spreadsheets.google.com/pub?key=0AuRRzs61sKqRdHVrZkV4VVBudUhjakpiLXBrZDIwZlE&output=html


Capital Structure 31.12.2010

Outstanding shares (m) 64
Market price RM  25.3.2011 16.22
Market capitalisation (m) 1038.08

Per Share
EPS 1.00
DPS 0.73
NAV 3.09
FCF 1.40

Valuation
P/E 16.25
EY 6.15%
P/B 5.26
DY% 4.47%
P/DIV 22.37
D/E 0.00
P/FCF 11.62
FCF/P 8.60%

ROA 20.78%
ROTC1 (TC= Eq+LTL+ STL-Cash) 57.14%
ROTC2 (TC= Eq+LTL-Cash) 57.14%
ROE 32.35%

Turnovers
Inventory Turnover (days) 59
Receivable Turnover (days) 34
Payable Turnover (days) 31

Business Prospects

After a relatively stable year for mild solid prices in 2010, we anticipate that prices for imported dairy raw materials will rise sharply starting early in 2011.  This is mainly a result of increasingly strong demand in upcoming markets and climatic changes affecting milk powder exporting countries.  It will unfortunately increase our input costs and likely to impact the bottom-line results for the financial year ending 31 December 2011.

Market Watch

Recent Financial Results

Announcement Date		Financial Yr. End		Qtr	Period End		Revenue RM '000		Profit/Lost RM'000		EPS		Net Pr. Marg
25-Feb-11		31-Dec-10		4	31-Dec-10		161,833		10,835		16.93		6.7%
29-Nov-10		31-Dec-10		3	30-Sep-10		186,715		13,322		20.82		7.13%
18-Aug-10		31-Dec-10		2	30-Jun-10		188,929		18,918		29.56		10.1%
18-May-10		31-Dec-10		1	31-Mar-10		173,111		20,812		32.52		12.0%