Daily Bitesize: The value today of a dividend tomorrow part II

In part one of this series of valuing dividends we looked at a simple Dividend Discount Model to understand the current share price of TeliaSonera, a telecommunications company that pays out a high dividend yield.

The assumptions required in this model, assured dividend payout and known dividend growth to eternity make this model in my eyes just slightly limited in its application! How can you seriously predict the dividend growth to infinity?? The less said about a company (or even the universe) existing for infinite amount of time the better!

Clearly we need to shorten the timeline....and dramatically. There are some ways around this but of course these modified models introduce their own assumptions. One way is to predict the dividends just a few years out, say for example 3 years, and then sell the stock at a predetermined price.

We then discount the sum of these dividends and the proceeds of stock sale at a certain discount rate. This is driven by the risk of investment and partly judgemental. Would I prefer $100 today or $105 next year? Perhaps then $110?

In the example below I have chosen 9%, for simplicities sake let's just say I like my money and the number nine! You are welcome to choose a higher or lower value, that's the beauty of the markets.

In example one (yellow) we have a 2.85 kr dividend being paid out for three years (i.e. no growth) and then sell the stock at today's price of 48kr. The sum of those pay outs and sale is discounted to give a present value. So for example the year 1 dividend is worth 2.85/1.09^1 which is 2.61kr, the year 2 dividend is 2.85/1.09^2= 2.40 and so forth.

As you can see the total price in today's money is 44kr, around 8% less than the current price. The second example (blue) has the dividend growing 5% each year but that doesn't really change the valuation at 45kr. Clearly over this relatively short period of time it is the selling price which drives the value.

As you can imagine one can modify the growth rate, discount rate and selling price ad ifinitum until you get a price you wish. The last example shows what selling price would be required in combination with 5% dividend growth and 9% discount rate i.e. 53kr to get a present value of around 48kr per share. This is now around 10% above the current market price.

Who knows what the future holds for TeliaSonera, maybe it will raise it's dividend in the near future, maybe it won't. If you value the company solely on its dividend and ignore other ways it may create value such as additional cash flow, reinvestment etc then it doesn't look a screaming buy.

However, let's change our mindset regarding this trade. We could be an optimist and conclude the stock may just be reasonably valued based on it's dividend and has upside potential as anything else it may produce would be a bonus.

Daily Bitesize: Simple yet effective

Was amazed to see Avanza Zero is the fourth best performing Swedish equity fund from the past 5 years. It's a simple index fund (SIX30RX) that buys the top 30 traded companies, plus has no fees! So simple yet so effective.

I also plan to write about some simple strategies that have been shown to increase returns in these type of index funds.

Daily Bitesize: The value today of a dividend tomorrow

'Price is what you pay. Value is what you get'-Warren Buffett

When buying a dividend paying stock it's prudent to know if you are getting value for your hard earned cash. Pay too much and it could take many years, if at all, to get your money back.

One very simple way of valuing an income stream from a dividend is the 

Dividend Discount Model DDM.

The discount rate is a measure of how highly you value your money today and is connected to the risk of the investment. The more precious your money and the higher the risk of the company/dividend then the higher the discount rate.

For example the 'risk free' discount rate would be 10-year government bond as you are certain to get your money back at the end (we'll ignore inflation at the moment!). Due to the risks associated with a companies stock the discount rate would be some percentage points above this, around 5%, give or take a few points.

TeliaSonera is a Sweden based telecommunications company, most countries have them and as is the case with these companies it pays out a high dividend of 6%, 2.85kr. It's the most owned stock by Swedes and has a pay-out ratio of around 62%, so returns a significant amount of its profits back to shareholders in the form of dividends.

We will try to value its stock price purely by its dividend and the cash flow it provides, as if it were a perpetual bond. Below is a table of valuations based on the equation above using different inputs for the discount rate and dividend growth rate.

Ignore the purple areas, that is where the calculation breaks down as the discount rate must always be higher than the growth rate (it's one of the limitations of the calculation). I've highlighted in green the combinations that closely match the current stock price of 47.8kr.

At one extreme we have TeliaSonera being evaluated by the market as having no dividend growth with a fairly low discount rate of 6%. As the growth rate increases then so can the discount rate to compensate for any extra risk.

It should be noted the Telia's dividend has grown since the lows of 2008 but is still below 2005 levels. That's a rear view analysis of the dividend and doesn't really tell us what will happen in the future.

So there you go, the share price doesn't seem extremely overvalued based on the simple dividend discount model but is a little bit too rich for my tastes. Certainly no bargain.

This valuation does assume however that the dividend will be paid out for an infinite period of time and as we all know the saying goes, 'in the long run we are all dead'!

More valuations coming in future parts.