Question

Dividends provide investors with a return on investment and are incorporated into the valuation process by many analysts. Discuss both the advantages and disadvantages of including future dividend payouts, especially pertaining to GROWTH companies, when attempting to value a company’s stock (DIVIDEND CONUNDRUM ISSUE). How accurate is a potential future dividend in determining a current stock price?

Answer 1

The dividend is one of the important ways in which the companies communicate the financial health and the shareholder value. Through a distribution from their earnings, companies indicate a positive future and a strong performance. The ability and the willingness of a company to pay stable dividends over a good period of time and even increase them steadily gives a good picture about the fundamentals of the company. Dividends are the stream of income from a stock and the present value of the future dividends provide a fair value of the firm involved.

To determine the value of a stock, valuation model uses future dividends to create a prediction on share values. It is based on the sole idea that investors are purchasing that stock to receive dividends.

Here are some key advantages and disadvantages when using the future dividend in valuation model

Advantages;

1. Stocks which pay dividends generally outperform stocks that do not. By using valuation model, it becomes easier to find a place to invest because you’ll be able to maintain the value of the investment. At the same time, you’ll earn income through the dividends being earned, which allows you to grow the overall value of your portfolio, especially if you’ve invested in several dividend stocks from a variety of industries.
2. One of the advantages that comes with the dividend valuation method is that a margin of safety is already built into it. You’ll be able to determine where the value stands, then assign a place of investment which works for your budget. That means you stay in control of when and how you invest.
3. The dividend valuation model was never designed to work with small businesses and startups. It is designed to be a measurement of the health of a mature business. Regular dividend payments are a sign that a company has entered the third stage of business development, which promotes profitability for investors. That makes it easier, compared to other valuation methods, to determine what the discount rate should be.

Disadvantage;

1. The reality of the investment world is that the dividends at a company are not going to grow at a specific rate until the end of time. Some companies increase their dividends over time. Others may reduce their dividends. Some have even chosen to eliminate them altogether. These actions are not part of the calculation process of the valuation model. That means this model is best used on the few companies which consistently provide a dividend growth rate each year.

2. There are many factors which can influence the valuation of a stock over time. Customer retention, brand loyalty, and even intangible asset ownership all have the potential to increase the value of the company. If the dividend growth rate is stable and known, these non-dividend factors can actually change the valuation of the company in question. That means the valuation method, even when calculated correctly, may not produce desired results

3. The idea that the only way to create profits from the actions of an investment is through dividends is a thought process which is fundamentally flawed. There are numerous ways to increase portfolio wealth by working with stocks, bonds, mutual funds, ETFs, and other financial products. Only looking at dividend stocks means a portfolio may not have the diversity required to make it through a period of economic recession

All securities can be valued by calculating the present value of their future cash flows.

The information needed to value a company is clearly stated in its financial statements. The Balance Sheet totals up the value of the Total Assets of a company and equates this to the value of the Total Liabilities plus the “Owner’s Equity”. Some simple algebra establishes that, at any point in time, the value of the “Owners’ Equity” of a company equals the value of its Total Assets minus its Total Liabilities.

The market price of a stock tends to move towards its intrinsic value. If the intrinsic value of a stock were above the current market price, the investor would purchase the stock. However, if the investor found, through analysis, that the intrinsic value of a stock was below the market price for the stock, the investor would sell the stock from their portfolio or take a short position in the stock