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Friday, August 4, 2017

Market Implied DGR - A Quick and Dirty Stock Valuation Method

By Catfishwizard

Coming up with a fair value of an individual stock is really hard, and can be as complicated as you want it to be.

I don’t like complicated, so I came up with a metric that I call Market Implied DGR to quickly give me a baseline of fair value from a dividend growth investing perspective.

I’d like to share that metric and my reasoning behind using it with you.

Before we get started though, I have a few housekeeping items to get through to make sure we’re on the same page.

I don’t believe 100% in the efficient market hypothesis and if you’re a dividend growth investor trying to identify undervalued individual stocks to invest in, you don’t either.

If the market were truly 100% efficient, then nothing could be undervalued or overvalued, it would just be … valued? In that case, one should just buy index funds, play golf and hope not to get wiped out by the sequence of returns risk when retiring.

There are a lot of people who adamantly oppose stock picking because they are so purely devoted to the Church of the Efficient Market. Many call themselves bogleheads or passive indexers or whatever. I call them stock market nihilists.

If you’re a stock market nihilist, you’re more than welcome to stick around, but you might want to skip this one and go have some lingonberry pancakes or something. This article is about how to determine individual stock valuations.

I do think that the market is pretty darn efficient. There are a lot of very smart people (and robots) constantly incorporating all the data available in the universe into the price of different market components. Those people (and robots) have more time and more resources than you or I do, and are probably way better at identifying (and exploiting) any minor market inefficiency that might happen to crop up.

In other words, we’re probably not going to "beat" the market because it is very, very efficient.

So basically I think the market is efficient and inefficient at the same time. Is that possible? Can light be both a wave and a particle? (hint: yes, yes it can)

Since I’m not a stock market nihilist, I’m picking individual stocks. And even though they’re probably fairly valued by the efficient market, I need to at least try to pick out ones that are better for me than the others somehow.

So here we are.

There are lots of ways to calculate a fair value for a stock, but they all revolve around one principle:
Use a projection of what the company is going to generate in the future, and discount it back to a present day dollar value. 
The formula is:
fair value = (thing you’re interested in) / (discount rate − growth rate of the thing)
The "thing" could be earnings, cash flow, book value, revenue, EBIDTA, dividends, or whatever. What the stock is worth in today’s dollars is a function of how much it’s going to grow relative to your expected return.

For some reason, a lot of the traditional stock valuation metrics use an inverted version of this formula. But it’s important to realize the numerator and denominator are arbitrary conventions.

For example, let’s say a stock has earnings per share of $2. We could use a 10% discount rate and project the company will grow earnings at a rate of 3.33%. Then the fair value is:
2/(0.1  0.0333) = $30.00/share
Or you could say that the stock is fairly valued at a PE (price to earnings) ratio of $30/2 = 15.0. It’s the same thing, just a different way to express it.

Or maybe you think a PE of 15.0 undervalues future earnings growth. This would imply that the expected growth rate of the earnings will be higher ... maybe 5%? In this case, we have:
2/(0.1  0.0500) = $40.00/share
or a PE of $40/2 = 20.0.

Wait ... why are we talking about earnings? We’re dividend growth investors! Earnings are great and all, but we’re interested in dividends. Show me the divies!

Okay, same formula, different input, and we have the Dividend Discount Model (DDM).
fair value = dividend / (discount rate  dividend growth rate)
If you are a dividend growth investor trying to pick out individual stocks that are undervalued, this formula should be familiar to you. If it isn’t familiar to you, or you’re having a hard time understanding it, you either need to spend some time at the library, or think about joining Uli in the pool!

If only stock valuation were this easy...

Well, stock valuation really is this easy ... you use the formula and it gives you the fair value. What is hard is knowing what growth rate and discount rate to use.

A small change either in the discount rate or the growth rate has an outsized effect on the fair value result.

We’re all familiar with the reason for this effect: it’s the power of compounding. Of course, the growth formula magnifies slight changes to the rates ... they’re GROWTH rates.

The discount rate is kind of a matter of personal preference, but there are limits to what’s reasonable. 10% is a commonly used discount rate, especially for stocks. If the historical average market return is about 7-8%, then by using a 10% discount, you’re building in a 20-30% margin of safety. That's a reasonable rate for evaluating stocks, and you should consider using it; most people do.

Which (finally) brings me around to the point of this article.

Earlier we wrapped our heads around the idea of a market that is both efficient and inefficient at the same time.

One way you might be able to justify the cognitive dissonance is to say that the market price of a stock incorporates the various projections of all participants of the growth rates of different valuable things (earnings, cash flow, book value, dividends, etc). But if you look at the fair value as a function of just one of those things (let’s say dividends), then in that context the market value could be disconnected from its fair value.

Said another way, let’s assume the market price of the shares is fair overall because the market is efficient. Is it just as fair from purely a dividend growth perspective? How would we know?

Well, instead of trying to guess at what the right growth rate is, we can just solve for it assuming the market price is fair:
fair value = dividend / (discount rate  growth rate) 
(fair value)×(discount rate)  (fair value)×(growth rate) = dividend 
(fair value)×(discount rate)  dividend = (fair value)×(growth rate) 
discount rate  (dividend / fair value) = growth rate
So, if we assume that we have the same discount rate as Mr. Market and it’s 10%, then:
10%  (dividend / fair value) = growth rate
And, since we're assuming that the current market price is fair, then we have:
10%  (dividend / market price) = market implied growth rate
10%  yield = market implied growth rate
If the market price is fair and the stock is yielding 3%, and if the market is using a 10% discount rate, then the market implied DGR is 7%. 

If the stock is a behemoth dividend champion with little growth prospects, leveraged to the hilt, with 3-yr, 5-yr and 10-yr DGRs around 3.5% and the company can barely cover its dividend payments with free cash flow, then maybe a market implied DGR of 7% is a little optimistic?

Conversely, if the company has a long runway of growth ahead of it, zero debt and generates gobs of free cash flow compared to its dividend, then maybe a market implied DGR of 7% is undervaluing future dividends.

There are two reasons why I like thinking about stocks in the context of the market implied DGR.

The first reason is that the formula is so simple that I can do it in my head in an instant:
10%  yield
That’s it!

The yield of dividend paying stocks is readily available, so I can always do a quick and dirty valuation with just a single step.

The second reason is that it’s easier for me to say whether I think a growth rate is maybe too high or too low than to come up with a specific value. It’s the difference between answering a closed and open question:
Is a 7% growth rate too optimistic? 
At what rate will the company grow its dividend?
And once you answer the closed question it’s a little easier to come up with the answer to the open question when you have a baseline.

Let's see how this works. Assume a stock XYZ is yielding 4%. Nice! That gives XYZ a market implied DGR of 6%. Is that reasonable? Based on what you know about the stock, you think the answer is yes. So, you think XYZ can grow its dividend at least 6% per year.

How about 7%? Do you think XYZ can grow its dividend by at least 7% per year? Now you're not so sure. Okay, so if XYZ's yield plunges to 3%, the stock is too expensive. So the fair value is somewhere in between.

Now you can look at the historical DGRs and payout ratios, read the 10-K's, listen to the earnings call or whatever you do to research stocks, to decide if your lower yield limit should be closer to 3% or 4%.

If this all sounds super hand-wavy and subjective, it’s because it is. There is no way to get around the fact that discounting future value back to the present value requires guessing what the growth rate is going to be, and slight changes to our guess will have a huge effect on the result.

Using the market to give you a baseline guess and then subjectively deciding if that guess is aggressive or conservative, is easier for me than coming up with my own number.

So that’s what I do.

What do you think? Is this all wrong?

Or are you ready to give up and join Uli in the pool of nihilism?

How do you determine the fair value of stocks?

I’m interested in hearing your comments!

This article was written by Catfishwizarda dividend growth investor and general enthusiast of all things financial. He has maintained the DGI Adventure Blog since September 2015. He especially likes trading options on dividend growth stocks to accelerate his returns during the accumulation phase. Soon he and Mrs Wizard hope to be financially independent, living off a steady, growing passive income stream from their investments. Please follow him on twitter at @CatfishWizard.

1 comment :

  1. I'm certainly going to apply this "quick and dirty" method when I consider stocks. Especially considering the outsized effect that a small change either in the discount rate or the growth rate has on a fair value estimation.

    In my DDM model for stock valuation, I use a 10% discount rate as a basis, but I also estimate fair values based on 9.5% and 10.5% discount rates.

    So which one do I end up using?

    If for a single stock, I use the 10%.

    But usually I simultaneously do a valuation for many stocks (at least 50 for my monthly "10 Dividend Growth Stocks" series of articles). In that case, one can use a correlation between the different fair value estimates and the stock prices to "choose" the most appropriate one to use.

    In fact, I average the estimates of the best and second best correlations to arrive at a fair value estimate. And I've expanded the set of estimates to 8 different variations of the available estimates.

    Thanks for a thought-provoking article!


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