“THE VALUE OF A SHARE DEPENDS ON ITS FUTURE DIVIDENDS”

“THE VALUE OF A SHARE DEPENDS ON ITS FUTURE DIVIDENDS” Dr Neoh Soon Kean

In my last posting on “Best Valuation Technique” posted in the link below, we saw that the P/E ratio valuation has numerous shortcomings.

http://klse.i3investor.com/blogs/kcchongnz/87147.jsp

Many of those hot stocks described in the article have earnings and continuous earnings growth and were selling at low single digit PE ratio; KNM, London Biscuits, Guan Chong, Ivory, Asia Media etc.

In all cases, earnings were illusive; earnings were one-time off in non-cash foreign exchange gain, revaluation or sale of asset etc., and often misleadingly booked as operating earnings. The quality earnings were poor with earnings hidden in build-up of inventories, doubtful and increasing receivables, and hence poor cash flows. Even if there is cash flow from operations but huge amount is required to reinvest in the business in plant and machineries, leaving nothing behind, and often have to borrow more, issuing more shares to get more money, just to keep its door open.

Investors using the simplistic PE ratio to chase after them had lost huge amount of money, most of the time just after they announced those earnings growth, and also after they announced the bonus issues, “free warrants” etc. when insiders, syndicates, fund managers, institutional investors took the golden opportunities to unload their shares to the naïve small time retail investors.

So how are you, as retail investors going to avoid falling into this pitfall when using PE ratio?

Yes, we have to go back to fundamentals of investing.

Fundamental determinants of PE ratio

In fundamental investing, we are not guessing about how the share price is going to move up or down in the near future, how investors will chase the share price when companies cutting the cakes by proposing bonus issues, share splits, free warrants etc. and in turn boast up their share prices. I have shared my thought about this issue in my article here:

http://klse.i3investor.com/blogs/kcchongnz/79280.jsp

Today I read an interesting article in Chinese in i3investor about the same topic here:

http://klse.i3investor.com/blogs/jade_and_gold/87457.jsp

In fundamental investing, we are looking at investing in a stock as if we are investing in a small portion of a business. What else should it be as when we are investing?

In The Theory of Investment Value, written over 50 years ago, John Burr Williams set forth the principle for value as:

“The value of any stock, bond, or business today is determined by the cash inflows and outflows—discounted at an appropriate interest rate—that can be expected to occur during the remaining life of the asset.”

The cash inflows to investors is of course not the illusive earnings, but dividends which is hard cash put into the pockets of investors. The cash flows or money in the future is not the same as money today, and hence the discount rate, with risks incorporated. “Remaining life” of course is not today, the next day, the next quarter or two, but at least a number of years.

In the simplest discounted cash flow model (DCFM) for equity, which is a stable growth DCFM. The value of equity is

Value of equity = Expected dividends next year / (Cost of equity, Re – Expected growth rate, g)…. Eq 1

There is some theoretical background here for those who are interested:

http://klse.i3investor.com/blogs/kcchongnz/83959.jsp

From equation 1, we can see that the value of a firm is a function of three variables:

1. Its capacity to generate cash flows, in this case in dividends
2. Expected growth rate
3. The uncertainties associated with this cash flows as estimated from its cost of equity; the higher the uncertainties, the higher is its cost of equity and hence the lower the discounted future cash flows.

You can see that this theoretical background though quite mathematical, is logical and intuitive, and not just purely theoretical. Of course it can’t be bullshit, or misleading. Jargon? May be not if you understand some algebra, or care to learn about it.

From Equation 1, with a little algebra, dividing both sides by the net income, we obtain the DCF equation specifying the PE ratio for a stable growth firm,

Value of a firm/Net income = PE = (dividend/ net income) / (Re – g) = Payout ratio / (Re – g)…Eq 2

From equation 2, we can see that other things remaining equal, we would expect higher growth, lower risk, and higher payout ratio firms to trade at higher multiples of earnings than firms without these characteristics.

This is definitely more intuitive than using just earnings growth, and a simplistic common PE ratio.

For firms which pay little or no dividend, one can replace it with the free cash flows as the numerator.

Let us do a simple valuation for a real company in Bursa, Padini Holding Berhad.

Fundamental PE ratio for Padini

I have written an article about the past performance of Padini and concluded it as a good company worthy of investing in as in the link here:

http://klse.i3investor.com/blogs/kcchongnz/85800.jsp

I have also carried out a couple of discounted cash flows analysis, first using dividends, and then free cash flows in the links below which shows that it was selling at a comfortable margin of safety:

http://klse.i3investor.com/blogs/kcchongnz/85828.jsp

http://klse.i3investor.com/blogs/kcchongnz/86127.jsp

The pay-out ratio of last year is 82%, and the previous year 72%. Taking the average of 77%, a required return of 10%, and a conservative long-term growth in dividend of 5%, the fundamental PE ratio of Padini is worked out to be 15.4

PE = 77% / (10% - 5%) = 15.4

With an estimated forward EPS of 15 sen next year, the fair value of Padini is estimated to be

Fair value, P = 15.4*0.15 = RM2.32

This represents a margin of safety of 21% over its closing price of RM1.83 on 2^nd December 2015.

Conclusions

The reasonable PE ratio of a stock shouldn’t be an arbitrary value. It should not be the same for companies in different industries, and even if in the same industry, it should not be the same. It has to be based on some fundamental determinants; they are the capacity to generate cash flows, expected growth rate and the uncertainties associated with these cash flows.

Of course one also has to ensure that this “E” in the PE ratio is a normalized and recurring, and true earnings unlike those in the link below in order to derive the fair price using this fundamental PE ratio:

http://klse.i3investor.com/blogs/kcchongnz/87147.jsp

In Padini’s case, its earnings is indeed has been the “true” earnings without any managing and manipulating, as observed from its stable and persistent free cash flows generations and increasing dividend payments as described in the previous article.

While the computations are based upon a stable growth dividend discount model, the conclusions hold even when we look at companies with high growth potential.

If you are interested to learn about the fundamentals of investing for a small fee, please contact me at

ckc14training2@gmail.com

K C Chong (3^rd December 2015)