4th letter to friends of Brunei [Stock Valutation (part 1)]

Assuming you are a fund manager of Singapore Growth Fund. How would you ascertain the intrinsic value of stocks in your portfolio? There are two ways of doing this. One by calculating the present value of the cash dividends of the stock; two by examining the earnings of the stock.

1. Present value of cash dividends [also known as Dividend Discount Model (DDM)]

Let's assume the stock will pay the same dividend year after year, for example a preference share. This is called zero-growth model. The intrinsic value of this stock can be calculated as follows:

P0 = d / k
P0 = Intrinsic value of stock
d = Fixed dividend expected for all future periods
k = Required rate of return for this stock.

Consider a preference share with a par value of $10 that pays a fixed dividend of 50 cents per share. If the required rate of return for this stock is 8%, then its intrinsic value is:

P0 = d / k = $0.50 / 0.08 = $6.25

What if the stock has a constant growth in dividend? Then we have slightly more steps to do. First, we need to calculate the dividend in the next period. Second, we divide this dividend value with [required rate of return – dividend growth rate].

P0 = d1 / (k – g)
d1 = Dividend in the next period [i.e. D0(1+g)]
k = Required rate of return
g = Dividend growth rate

Let's do one example: The Krehbiel Corporation 's required rate of return is 10%. Krehbiel's current cash dividends per share are $2.50 and have been growing at 3% per year. What do you expect the stock price will be?

Krehbiel Corp's Stock price (P0) = $2.5(1+ 0.03) / [0.1 – 0.03] = $2.575 / 0.07 = $36.79

What if the dividend rate has declined in the next year? No problem, let's look at another example: The Tucker Mining Company has been experiencing a 6% per year decline in its cash dividend growth rate for the past few years; this decline is expected to continue. Tucker has a current dividend per share of $3. If Tucker's required rate of return is 14.5%, what is a share of the stock worth?

Tucker Co's Stock price (P0) = $3(1+ -0.06) / [0.145 – (-0.06)] = $2.82 / 0.205 = $13.76