The present worth of a constant stream of cash flow to infinity (and beyond!) is P = A/I where A is the constant rate of cash flow over some period and I is the interest rate over the same period. However, if the cash flow is increasing geometricly at some rate G, then the present worth is P = A/(I-G) (assuming G < I, for G > I, P is unbounded.) Now, if one assumes that dividends follow earnings or in the case where a company that does not pay dividends COULD BE BOUGHT FOR CASH BY SOME OTHER CONCERN (the other meaning of LBO!), it can be seen why following a stock's earnings is important. For example, with G=0, the present worth of a company with a cash flow of $1 million dollars a year and a discount rate I of 8% is $12.5 million. However if the growth rate, G = 4%/year, then the present worth is $25 million. Fiddling with G just a little has a big impact on the present worth and playing options or using margin magnifies the effect even more. The rub is that nobody knows what G will really be in the future and of course, the trick to investing is to beat everyone else to the punch, so you end up with some really wide swings in a stock's price as investors try to get a fix on the anticipated changes in a company's future earnings.
Chuck Huron Valley Greens (Ann Arbor Michigan)
----- Original Message ----- From: "Doug Henwood" <dhenwood at panix.com> To: <lbo-talk at lbo-talk.org> Sent: Tuesday, August 09, 2005 8:58 PM Subject: [lbo-talk] re: stock valuation without dividends
> Alex wrote:
>
>>I've heard the story about how earnings per share can
>>replace dividends, but it never made sense to me.
>>Stock owners never actually get non-dividend earnings.
>> They are simply informed of them on the quarterly
>>balance sheet before they are reinvested. Stock
>>holders are never actually given that money, so the
>>earnings only value to investors would be on the
>>assumption that the reinvestment will lead to greater
>>dividends in the future. The price model would then
>>have to be changed to include how the expected return
>>on the investments would affect the quantity and
>>timing of future dividends that they are expected to
>>lead to. This seems highly dubious. In sum, earnings
>>certainly can't be simply be interchangeable with
>>dividends in any valuation model because investors
>>aren't actually paid earnings whereas dividends have
>>real value.
>
> You're betraying a very old-fashioned way of thinking! There was a time
> when some people bought stock for dividends, but now only fuddy-duddies
> and retirees do. It's all about what the price is going to be tomorrow, or
> next month, or next year, when you hope to sell it for a capital gain.
> Since stock prices are at least partly determined by underlying profits,
> the best guess you can have for the price at which you'll unload the
> shares is some multiple of future profits. It's one step this side of
> alchemy, but that's the rationale.
>
> Speaking of stock trading, it seems that on the first day of trading in
> that Chinese Google, Baidu, the average share turned over ten times.
>
> Doug
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