Is there value in using dividends to valuate a company?

In my previous post, we challenged the long-held belief in looking at annual rate of return on investment as a measure of investment success. Maybe there is another way to rethink the notion of investment success by looking at how fast one accumulates his investment capital over a period of time (his rate of accumulation of capital)? On this same note, perhaps there is some value in seeing dividends serving this purpose of capital accumulation by reinvesting the earned dividends back to increase one's portfolio value and also work on the principle of compound interest growth to further receive more future dividends upon a larger portfolio with the reinvested dividends.

It is no wonder that compound interest growth is the 9th wonder of this world - principle of interest received upon interest reinvested. The higher the amount of interest in consideration and the higher the rate of interest received, the faster this 9th wonder of the world works to double the original capital value. One may have already heard of the principle of 72 in calculating the number of years needed for one's capital to double by compound interest growth. Just divide the number "72" by the compound interest growth rate and one will know how long it takes for an original capital sum to double. E.g. if one can receive a consistent compound interest rate of 10% annually, it will take approximately 7.2 years (72 / 10 = 7.2 years) for one's original capital sum to double assuming all dividends received from one's portfolio are reinvested.

If one started with a $100,000 capital sum, 7.2 years later he will have approximately $200,000 by compound interest growth at 10% compounded interest rate. One can imagine the effect is enormous when dealing with larger capital sum. A starting capital of $500,000 in the same case with be worth $1 million in approximately 7.2 years time.

The two important factors here will be the amount of start-up capital and compound interest rate. Many of us are limited by our start-up capital. Not all people start on the same equal footing. Some start on a more substantial capital sum while others start with a smaller sum when embarking on this journey of investment. Since one is limited by his start-up capital, the second factor (compound interest rate) now plays an important role in determining how fast one can keep doubling his capital.

How nice if one can continue to receive year after year dividends that grow at a rate faster than inflation? The higher the annual rate of growth of dividends, the higher the compound interest rate one receives if one can successfully reinvest all the dividends consistently at high yields. Therein lies the importance of dividends, especially dividends that prove to be consistently growing at high rate annually.

However, there is another perspective in some investors preferring the company not to provide dividends but instead reinvest it's earnings to grow it's business competitive moat and assets so as to generate even more future earnings and potentially increasing the share price. If the company can do a better job at reinvesting it's earnings to generate better future returns for it's shareholders than they receiving the dividends which they can only reinvest at lower returns, it maybe better for the company to do so. The future is unknown, so the merit of whichever choice be it for a company to provide some dividends out of it's earnings or to reinvest all it's earnings is known only on hindsight.

Since dividends may be considered as important and a consistently growing dividends at high yield annually is desirable, one can use dividends as a means to valuate a company's intrinsic value per share.

The relevant equation adapted from dividend discount model (DDM) to estimate a company's intrinsic value per share is as follows:-

R = Cost of capital

G = Compounded growth rate of dividends

Just a simple case study for estimating the intrinsic value per share for one of my invested companies, Keppel Corporation. Keppel Corp has seen it's dividends grow at a compounded rate of around 11% over the past 7 years. It's most recent dividends is $0.42 per share. I shall use a cost of capital of 14% as my opportunity cost in investing in Keppel Corp.

Putting all the information into the equation gives:-

= $14

Intrinsic value per share is only at best an estimate. If one uses a higher cost of capital (e.g. 15%) in the equation, the estimated intrinsic value per share now becomes $10.50. The current market price for Keppel Corp's share is $11.40 per share. So, if one uses a higher cost of capital (15%), the estimated intrinsic value per share is lower at $10.50 and now Keppel Corp's current market share value seems to be overvalued. But, if one uses a lower cost of capital (14%), Keppel Corp's current market share value of $11.40 per share will now seem to be still undervalued compared to estimated intrinsic value of $14 per share. Thus, estimation of intrinsic value per share is only a subjective fuzzy guide. The investor needs to invest at a valuation much lower than the estimated intrinsic value per share to ensure a margin of safety.

The value in looking at dividends in estimating intrinsic value per share for a company is that one is also looking at the track record of the company in giving dividends. A good track record is always welcomed. A company like Keppel Corp that has provided a good 7 years of dividends that grow at a compounded annual rate of 11% may have a fair chance of continuing it's track record. Of course, in everything due diligence is needed to also look at other aspects of a company and not it's track record in dividends alone.

In conclusion, is there value afterall in using dividends to valuate a company? Is dividends valuable to an investor? Yes, it is valuable to a certain extent as long as the company can continue to provide a reliable stream of dividends that grow at a high annual compounded rate. Even better is the investor that continues to receive that stream of dividends at a high yield (more than 10% annually).

How to know whether an investor has succeeded??

It is known to many that one looks at investment success in terms of rate of return on investment. If an investor can receive consistent annual high rates of returns on his original capital, he is deemed to be successful. The higher the annual rate of returns and the more consistent he can keep receiving the high rate of returns on investment, the more successful he is.

This brings us to the question of whether this long held belief is a good measure of investment success or not. I believe there is no harm in challenging every beliefs in life, and that includes investment beliefs as well. By challenging beliefs, one is not trying to be difficult and go against the beliefs but rather to seek the truth, to see whether the belief in question is really the ideal truth or not.

Is annual rate of returns on investment a good measure of investment success? Let's look at two separate fictitious people, Alan and Jane who did their investments differently. Alan is an investor who goes for high annual rate of return on his investments. He recognises the need to invest long term in good dividend stocks that provide a high yield. He also recognises the need to go for high capital gain every year, so he carefully selects some stocks that he thinks have good potential to grow their share price in any year. Alan has been doing well so far, getting reasonably good average annual rate of return (around 18%) on his original capital though his rate of return may change every year.

The only thing about Alan is that he reinvested little of his earnings from investments, so his investment capital value has not grown much throughout the years even though he continues to receive dividends and capital gains yearly which he spends away most of these earnings. When Alan talked to his friends about his investments, he always smiled with pride that he managed to get consistently good average annual rate of returns.

Jane another investor shares the same investment thoughts as Alan carefully selecting good dividend stocks with high yield to invest for the long term. She also looks out to invest in good growth companies that show potential to increase their share price be it on short term or longer term. In doing so, she is also hoping for good capital gain on her investments apart from receiving cashflows from dividend stocks. She is not as good as Alan in getting a high annual rate of returns on her investments. She managed to receive on average around 11% annual rate of return  on her investments. She diligently reinvest her earnings from investments throughout the years during opportunate times when valuations of companies are cheap.

Alan started with $100,000. After 20 years, his portfolio investment value has grown to $300,000. Jane started also with $100,000. After the same 20 years, her portfolio investment value has grown to $800,000. So, at the earlier part of both their investing journeys, Alan seems to be the better investor getting a higher average annual rate of return on his investments than Jane. However, he only reinvested little amount of his earnings from investments and mostly spends the rest of his earnings. He was thinking to himself all along that he was successful at getting a high average annual rate of returns on his investments.

Jane recognised the value of compound interest growth, so she delays her immediate gratification on spending her earnings from investments and instead plough back her earnings from investments to work on the principle of compound interest growth. Her efforts are finally realised only after a sufficient long period of consistent and diligent reinvesting, greatly increasing her original capital sum.

She has a higher capital value in investments than Alan after 20 years even though she made lesser average annual rate of returns on her investments throughout this period. In doing so, she managed to have a higher rate of accumulation of capital compared to Alan over the same period of time for the same start-up capital, since she has accumulated a capital sum through investing which is much higher than Alan.

I shall leave you with a final question. Is annual rate of returns on investments really a good measure of eventual investment success or maybe it is time to relook at this long held belief and consider another possible measure, the annual rate of accumulation of investment capital?