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).