Investing is based on the premise that an asset’s value is the cash flow that it generates over its lifetime, discounted to the present. This applies to all assets classes.
For real estate, the cash flow generated is rent. For bonds, it’s the coupon. For companies, it is profits.
In the case of stocks, investors may use cash flow to the firm to value a company. Let’s call this the DCFF (discounted cashflow to the firm) model. But valuing a stock based on cash flow to the firm may not always be accurate for shareholders.
This is because free cash flow generated by the firm does not equate to cash returned to the shareholder.
Take for instance, two identical companies. Both generate $1 per share in free cash flow for 10 years. Company A hoards all the cash for 10 years before finally returning it to shareholders. Company B, however, returns the $1 in free cash flow generated to shareholders at the end of each year.
Investors who use a DCFF model will value both companies equally. But the actual cash returned to shareholders is different for the two companies. Company B should be more valuable to shareholders as they are receiving cash on a more timely basis.
To avoid falling for this “valuation trap”, we should use a dividend discount model instead of a DCFF model.
Companies trading below net cash
The timing of cash returned to shareholder matters a lot to the value of a stock.
This is also why we occasionally see companies trading below the net cash on its balance sheet.
If you use a DCFF model, cash on the balance sheet is not discounted. As such, a company that will generate positive cash flows over its lifetime should technically never be valued below its net cash if you are relying on a DCFF model.
However, this again assumes that shareholders will be paid out immediately from the balance sheet. The reality is often very different. Companies may withhold payment to shareholders, leaving shareholders waiting for years to receive the cash.
Double counting
Using the DCFF model may also result in double counting.
For instance, a company may generate free cash flow but use that cash to acquire another company for growth. For valuation purposes, that $1 has been invested so should not be included when valuing the asset.
Including this free cash flow generated in a DCFF model results in double counting the cash.
Don’t forget the taxes
Not only is the DCFF model an inaccurate proxy for cash flow to shareholders, investors also often forget that shareholders may have to pay taxes on dividends earned.
This tax eats into shareholder returns and should be included in all models. For instance, non residents of America have to pay withholding taxes of up to 30% on all dividends earned from US stocks.
When modelling the value of a company, we should factor this withholding taxes into our valuation model.
This is important for long term investors who want to hold the stock for long periods or even for perpetuity. In this case, returns are based solely on dividends, rather than selling the stock.
The challenges of the DDM
To me, the dividend discount model is the better way to value a stock as a shareholder. However, using the dividend discount model effectively has its own challenges.
For one, dividends are not easy to predict. Many companies in their growth phase are not actively paying a dividend, making it difficult for investors to predict the pattern of future dividend payments.
Our best guess is to see the revenue growth trajectory and to make a reasonable estimate as to when management will decide to start paying a dividend.
In some cases, companies may have a current policy to use all its cash flow to buyback shares. This is another form of growth investment for the firm as it decreases outstanding shares.
We should also factor these capital allocation policies into our models to make a better guess of how much dividends will be paid in the future which will determine the true value of the company today.
Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life. I don’t have a vested interest in any company mentioned. Holdings are subject to change at any time.