Valuing Stocks Using Dividends

A stock represents a small part of a company. It is part of the equity (ownership) of the underlying company and provides the holder with a vote (usually one per share) and potential capital appreciation, as well as dividends. This ownership stake fluctuates and is valued daily in the market. But how does one determine what the correct stock price valuation is?

The value of a stock in its simplest sense is the present value of the cash flow expected to be provided by that stock. Cash flow usually takes the form of a dividend, declared by the company’s Board of Directors. It follows that a stock can then be valued as the present value of future dividend payments.

The rate at which the dividend is discounted is called the discount rate. Assuming dividends grow at a constant rate to eternity (a rather absurd assumption – investors usually use this model for certain time periods of say ten or twenty years), the stock can be valued using this growth rate and the discount rate.

The dividend discount model, a formula used widely in stock valuation, uses the future value of dividends to determine the current value of a stock. The formula to produces such valuation says that price is equal to the dividend divided by the discount rate less the growth rate of that divided. It can be written P=D / (k-g), where k is the discount rate and g is the dividend growth rate.

The discount rate is the measure of risk that must be assumed when purchasing a stock. For example, if one is buying shares of Coca-Cola (KO), which has predictable cash flows and dividends, the discount rate will be low, say 10%. However when one is buying a company with uncertain cash flows and dividends, the rate will be high, say 15%. This rate is a subjective measure and is effectively the rate required to assume the risk of investing in the stock.

Now for an example:

Johnson & Johnson (JNJ) currently trades at $64.90. An investor in search of a dividend yield wants to know if this is a fair value for the stock, in order to avoid over-paying. The current dividend on Johnson & Johnson is $1.93. If an investor, being conservative as he is, decides that a dividend growth rate of 7% annually into eternity is appropriate, then g would be 7%, or 0.08.

As for the discount rate, Johnson & Johnson is a great company with strong historical dividends and cash flows, and it’s almost certain the business will continue to generate cash in future years. As such a discount rate of 10% is probably appropriate (in the formula this would be 0.1).

Using the dividend discount model, P=D / (k-g), we substitute the above variables as: P=1.93 / (0.1-0.07). Solving this equation produces an answer of $64.33, or almost exactly the current stock price. Using this logic, Johnson and Johnson is a good purchase at the current price for dividend-seeking investors.

This model also allows investors to protect themselves from overpaying for expected dividend streams. Assume Merck’s (MRK) dividend to increase at 5% per annum from the 2009 payout of $1.52. Given the risks facing Merck of increased competition from generic producers, a cautious investor would use a higher discount rate, say 15%, to compensate for the increased risk of owning the company. Using the formula, P=1.52 / (0.15-0.05), and therefore P=15.2. Compare this to the current Merck price of $33 and one can see that this dividend stream may be expensive.

The dividend discount model is in no way a sure-fire guaranteed way to accurately value stocks. It does, however, provide the cautious dividend seeking investor some idea of the true value of a future dividend stream and can prove valuable in not overpaying for this stream. Conservative estimates should always be used ahead of more optimistic appraisals, and of equal importance is the financial strength of the company, which can be attained by a quick look through the balance sheet.

Dividend Investing: Mercury General Corporation (MCY)

The Company's operating results and growth have allowed it to consistently generate positive cash flow from operations, which was approximately $189 million and $65 million in 2009 and 2008, respectively. Cash flow from operations has been used to pay shareholder dividends and to help support growth. The dividend has grown over the last five years at a compound annual growth rate of 7.8%, and currently yields 5.29%.

At the current stock price of $44.48, Mercury is trading on an undemanding PE ratio of 6.11 and a somewhat generous price to book value of 1.38 times. Caution however must be warranted given the extraordinarily high profits the company realized in fiscal 2009 resulting from realized gains of $341 million. This was however after a realized loss of $551 million in 2008 during the height of the financial market crisis. On normalized basis earnings were around about $3 per share (this excludes unusual items such as realized gains or losses on large parts of an insurance company's equity portfolio, as well as a subsequently adjusted tax rate). That puts the company on a historical PE of about 14.82 times.

However the company is on a less than 6 times price to cash flow and a price to sales ratio of 0.78, which indicates investors can pick up more sales per share for a lower price. The outlook in terms of investment returns is set to prove and the underwriting margin should also normalize after relatively high claims during fiscal 2009.

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Verizon and Too Much Cash Syndrome

Verizon (VZ), the second largest communications company in America, has too much cash and they don’t know what to do with it. The firm has almost 100 million wireless users, or about 36% of the United States mobile market. That’s about the same number as all the mobile subscribers in Canada and Mexico combined.

With such a massive recurring revenue stream and resultant cash flows, Verizon has amassed a massive pile of cash of $2.5 billion. That’s about 3% of the value of the entire company, at a market capitalization of $85 billion. It's been at $10 billion just a few years ago and may even return to those levels. That cash pile is only going to grow – the company generates over $30 billion in cash per year.

Having such a large cash pile explains why the company trades at a dividend yield of 6.38%. That yield is one the highest on the market from a blue chip stock and is likely to remain either at or around a similar level going forward. Or it could be lower. I make no predictions.

Currently there is in existence a share buyback program which commenced in 2008 and allows the company to buy back 100 million of its shares. That’s about 1.17% each year. There were no repurchases of common stock during 2009. During 2008 and 2007, the company repurchased $1.4 billion and $2.8 billion of common stock, respectively.

So, with so much cash being generated, and with such a high dividend being paid out, what is Verizon going to do with all the extra cash?

Something really ridiculously silly, in my humble opinion.

According to a press release issued on Friday, “Verizon Communications Inc. will list its stock on the NASDAQ exchange along with its existing New York Stock Exchange listing. Verizon, whose ticker symbol is "VZ," has approximately 2.5 million share owners and approximately 2.8 billion shares of common stock outstanding. Verizon has a broad and diverse shareholder base, and we believe that the additional support provided by dual listing will benefit our current and potential investors.”

The annual listing fee for the NASDAQ is $95,000. There’s also an initial listing fee of $150,000. Assuming the above press release is correct, the average investor in Verizon has about $32,000 invested in the company. Just how making the shares trade on another exchange with little or no benefit to the “average” investor makes no sense to me whatsoever. Does Verizon want to increase the shareholder base to 5 million by “doubling” liquidity? What is the point of having millions of shareholders with little to no net worth in the company? There are also tremendous costs to mail out circulars and documentation to these investors, most of whom I’m guessing don’t read 10-Ks or Annual Reports.

There are a lot of academic studies that show managers with very large cash holdings can sometimes be lulled into a false sense of security and do things that are not beneficial to shareholders. This is one case in point. Listing in another exchange only serves to increase liquidity which encourages investors to trade frequently. It should be the goal of management to seek out long-term, dividend oriented investors who want to own a stake in one of America’s great companies. A secondary listing will not achieve this objective and is a cost to shareholders. Verizon is not a charity; it is a company operating for the ultimate benefit of the owners of its common stock.

I might just contact the other 2.45 million shareholders who hold 1,100 shares and start a proxy fight.

I originally published this article at BestCashCow.