What is the Ultimate Driver of Stock Values?

John Burr Williams.

That name probably doesn’t ring a bell to most of you. However, in 1938, he developed one of the stalwarts in the finance industry relating to the valuation of stocks.

If you remember from a previous post, I said that the ability of a company to generate earnings and then convert into cash flow determines its value. Williams’ theory focuses on cash flows, which for stocks are of course dividends. A dollar today is worth more than a dollar in the future. Therefore, we must discount any future cash flows into today’s dollars.

Dividends are finite (specific amount paid on a specific date), have low volatility, and are representative of earnings. They represent the long-term earnings potential of a company. A company’s Board of Directors, not management, sets its dividend policy, and usually follows a set pattern (monthly, quarterly, semi-annually, & annually). A company will go to great extents to keep its dividend policy stable. For example, a few years ago when BP had that major oil spill in the Gulf of Mexico, it maintained its dividend even though it suffered significant short-term losses. A cut in the dividend would have sent a negative message to the market that the company could not survive this major disaster. It did, and it is still one of the world’s leading oil & gas companies.

Steps to Valuing a Company Based on its Dividend

Let’s use BP as an example. At the time of this writing, BP was trading at $44.63 per share. Its annual dividend was $2.395 per share. We can manually calculate the dividend as well. The dividend is equal to EPS times the dividend payout ratio. BP’s Earnings per share was $2.808. With a payout ratio of 85.28%, that gives us a dividend of $2.395 (2.808*.8528). You can get all of this information from any finance website like Yahoo or E-trade. However, I want you to understand the fundamentals behind the numbers. If our dividend equals $2.395 and the price is $44.63, the yield must be 5.37% (2.395/44.63).

There are a couple of variations to Williams’ dividend discount model (DDM) used to calculate valuations. Both require a couple of assumptions. The first is required rate of return (k). In a future post, I’ll discuss in depth how to calculate it. But for now, we’ll go with a conservative number of 8%. The other is the growth rate (g). In that future post, I’ll cover this as well. For now, we’ll us the current growth of GDP, which is 3%.

The first formula is Value (V) = Dividend one year from now (D1) + Price one year from now (P1) divided by 1 + Required Return (k) or V = (D1+P1)/(1+r). We use the growth rate to calculate D1 and P1. D1= 2.395*1.03 = 2.4668. P1= 44.63*1.03=45.97. Inputting these numbers, our price equals (2.4668+45.97)/1.08 or $44.84.

The second formula is V = D1/ (k-g). Inputting our numbers, we get 2.4668/ (.08-.03) = 49.37.

Why the difference? The first formula is heavily dependent on the price one year from now. The second formula is dependent on our estimates for required return and growth.

Conclusion

Dividends have always been a main driver in equity values, and that isn’t going to change anytime soon. The known quantity (cash flow) always outweighs the unknown (future cash flows or price gains). They are appropriate for valuing stable, mature companies with a steady history of earnings like Coca Cola or ExxonMobil. In a future post, I’ll show you some methods for valuing companies that don’t pay dividends. For now, know that you’ll have a solid investment with a company that pays a steady dividend based on its earnings that yields over 5%.

Let me know what other finance topics you’d like to see discussed!

See you next time