Richard Russell
When you break down the concept of investing to the basics, there are two ways for an investor to make money: You can make a capital gain, and you can collect a dividend. Professor Jeremy Siegel of The Wharton School, showed that throughout history through to the early 1990′s, roughly three quarters of the real return from the stock market came from dividends, with only one quarter from capital gains. The conclusion of this analysis is that investors are wise to pay attention to the importance of dividends. In addition to being a means for distributing profits, dividends are importantly as a way of sending a powerful positive message to shareholders about the company's performance and its prospects.
Dividends have become a popular valuation items used to estimate the intrinsic value of a stock. But where does a company ideally obtain the cash to pay dividends?
It is from the old boring, theoretical, blindly-follow-the-book, should-be-forgotten-about-financial-jargon, too-long-waiting, of free cash flow. Here it goes again.
What is free cash flow, FCF and how important is it? I have been a broken record talking about it. But in my personal opinion, it is very important for investors to understand as shown in some links here:
http://klse.i3investor.com/blogs/kcchongnz/48173.jsp
http://klse.i3investor.com/blogs/kcchongnz/76694.jsp
http://klse.i3investor.com/blogs/kcchongnz/78262.jsp
http://klse.i3investor.com/blogs/kcchongnz/83903.jsp
This FCF is not just some useless theoretical, academic, or financial jargon, but a simple and logical, down-to-earth investing logic.
“Keep your eye on free cash flow”, Warren Buffett used to say. It is in Buffett’s play book.
Pintaras Jaya, Free Cash Flows and Dividend
Table 1 below shows the FCF and dividend payment of Pintaras Jaya for the last twelve years from 2004 to 2015.
Table 1: FCF and dividend of Pintaras Jaya
It can be clearly seen Pintaras has positive FCF every year over a full economic cycle of 13 years history, a feat not easy to match by other construction companies. In fact, there is a clear uptrend in FCF over the years as shown in Figure 1 below.
History or merely past financial results and not important in future investing outcome? Well this is what Mark Twain says:
“History doesn’t repeat but it does rhyme”.
Well, I place more emphasis on history than the words of snake oil salesman of Paul the Octopus.
It is this stable FCF that Pintaras has been able to pay an increasing dividend from 2 sen to 18 sen per share over the years from 2004 to 2015. There is not a single year which dividend was cut, not even during the US subprime housing crisis. Instead there was high increase in dividend payment during those years as shown in Table 1 above. For example, dividend increased by 67% in 2009, 50% in 2010. Not a single additional sen is taken from the existing shareholders, nor from the banks to pay all these dividends. That was because of the abundant FCF and huge amount of cash in its balance sheets, with zero debts. It is still having abundant FCF now and cash in its balance sheet amounting to RM1.08 per share, with zero debt.
The steady dividend payment makes it easy to estimate cash flows to shareholders and to use a discount cash flow analysis to estimate the intrinsic value of Pintaras without too much subjectivity as other methods do.
Dividend Discount Model (DDM)
Financial theory postulated by John Burr Williams in his “The theory of investment value” postulates 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.
DDM starts with the premise that that a stock's price should be equal to the sum of its current and future dividends, after taking the "time value of money" into account. This is because the value of money of today is worth much more than the same amount say ten years later because of inflation, opportunity costs and the risk associated with the magnitude of expected cash flows.
Although this is theory but it is very much practical, intuitive and a useful tool in real life investment. It is actually not that difficult too if one cares to pay a little attention to it. Here it goes.
Stock Price = the Sum of the Present Value of All Future Dividends
Or, more precisely,
Price = D1 / (1+r)1 + D2 / (1+r)2 + D3 / (1+r)3 +….Dn / (1+r)n = ∑ (Dt / (1 + r)t)
Where,
t = period
Dt = dividend during period t
r = required rate of return on the stock, or the discount rate
If the rate of growth in dividend is constant at g, ie D2 = D1*(1+g), D3 = D2*(1+g), D4 = D3*(1+g) etc.
Or D2 = D1*(1+g), D3 = D1*(1+g)2, D4 = D1*(1+g)3 etc.
Using a little algebra which one needs not to know exactly how, we can derive the formula
Price = D1 / (r-g) as t tends to infinity.
The above equation is the Gordon Constant Dividend Growth Model, mainly applied to value mature companies which dividends are expected to grow at the same rate, g, forever.
When dividends are not expected to grow at a constant rate, we have to evaluate each year's dividends separately, incorporating each year's expected dividend growth rate. However, the model does assume that dividend growth eventually becomes constant as the company grows to a mature phase.
Valuing Pintaras Jaya using DDM
As shown in Table 1 above, Pintaras’s dividend payment has been growing from 5 sen in 2009 to 18 sen for the fiscal year ending 30 June 2015, for compounded annual growth rate (CAGR) of 24%. This is in tandem with its CAGR of earnings of 21.6% of the same period. With this type of growth in earnings and dividend, what is the fair value of the share price of Pintaras?
Here, we will use the expected dividend payment for the next 10 years, and then a dividend growth rate according to the rate of inflation after that as the company becomes a more matured company. The future dividend payments are discounted to the present value. This is essentially a two-stage dividend growth model; one at supernormal growth and the other, a terminal growth.
As Pintaras has stable earnings and cash flows all these years and a healthy balance sheet with abundant cash and no debts, we use a discount rate of 9.5% as estimated from the interest environment now, the industry it is in, the stability of its earnings and cash flow and the health of its balance sheet. Academicians may use the capital asset pricing model which I would say is really theoretical and not useful or intuitive and hence although I am good at it, I don’t use it.
We have to bear in mind that as the company grows bigger, it is hard to maintain its past 6-year high dividend growth rate of 24%. Here we assume for the next 10 years, its dividend will grow at half its past 10-year rate, or 12%, and then grow at the inflation rate of 4% subsequently. I would say these are reasonable assumptions.
Value of a growing dividend
The first part of the computation of the present value of the dividend is the growing dividend from year 1 to year 10, or during the period of supernormal growth. Using a growing annuity formula
PVGA = C1 / (r-g) * [1- {(1+g) / (1+r)}n]
First payment in year 1, C1= C0*(1+g) = 18 sen*(1+12%) = 20.2 sen
Where C0 is this year’s dividend, C1 is next year’s dividend
Required return, r = 9.5%,
Supernormal growth rate, g = 12%
Number of supernormal growth, n = 10 years
We get present value of the growing dividend up to 10 years using the above formula
PVGA= 204 sen, or RM2.04
Terminal Value
The terminal value after 10 years C11 / (r-g1)
Where C11 is the dividend in year 11, g1 = 4% is the terminal growth rate forever after year 10.
C11 = C10*(1+4%) = 18*(1+12%)^10 * (1+4%) = 58.1 sen
Terminal value at year 10 = 58.1 / (9.5%-4%) = 1057 sen
Present value of terminal value = 1057 / (1+9.5%)^10 = 426 sen, or RM4.26
Total present value
Total present value of expected future dividends = PV of growing annuity + PV terminal Value
= RM2.04 + RM4.26 = RM6.30
Computation using spreadsheet
Table 2 in the appendix show the data and assumptions and the two-stage DDM computed using a spreadsheet. The present value of all future dividends using this method is shown to be RM6.30 per share, representing a margin of safety of 47% investing in Pintaras at today’s price of RM3.33 on 30th September 2015. Pintaras Jaya is still undervalued according to this DDM with the assumptions which in my opinion, is reasonable.
Figure 1 below shows the estimated future and present value of dividend payments over the next fifty years. Yes, 50 years, not only left 3 years and right 3 years. As value investors investing to build long-term wealth, we can wait for six (3+3) years, not 50 years though as the time duration is just used to estimate all future cash flows as required for the model.
The blue values are the actual dividends you expect to be paid if the dividend grows by 12% per year for the next 10 years and 4% subsequently. The red values are the discounted versions of those dividends at a discount rate of 9.5%; the dividends translated into today’s value. As can be seen, if this chart continues forever, the sum of all dividends would be infinite, but the sum of all discounted dividends is finite, because the discount rate is larger than the dividend growth rate after the tenth year, with the discounted value shrinking smaller and becoming insignificant to its present value as the years go by.
Conclusion
DDM provides a simple way to value stocks based on the dividends that they pay, and dividends are real cash investors receive instead of the doubtful earnings. However it is useless if the companies do not pay any dividend. Some companies may choose to focus on growth and invest their profits back into the company. According to this model, the stocks of those companies would not be worth anything. However, we know that a lot of these companies are very valuable and profitable, even though their dividend pay-out is low or even non-existent. This is because dividends not paid today becomes retained earnings that generate higher dividends in the future, and it can be shown that the present value of those dividends is unchanged, no matter when they are paid, unless the earnings retained does not earns the same rate of return as its required return on equity.
Finally sorry for the hard selling and an advertisement again. I really like to teach and propagate fundamental investing, and at the same time earn some money. You know though many people make big money, it is hard for me to make money in the stock market now. With the depreciating Ringgit, GST, inflation etc., life is tough, sigh. But that is precisely one needs to know how to invest wisely and safely for your retirement and other goals.
For those who wish to learn all this stuff, please contact me at
ckc14training@gmail.com
K C Chong (6th October 2015)
Appendix
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