How can investors use cash flows to improve stock analysis

Reference no: EM133632137

Finance

Activity 1: Group Case Study

You must form groups of 4 to 5 members before Week 12.

All questions for the group case study are based on the article on the following page.
You will complete the questions in your group, but only one group member needs to submit the final answers (for the entire group).

Activity 2: Individual Test

The individual test will take place after the group case study. The test will consist of short answer questions and multiple choice questions.

Are dividends more important than earnings for stock valuation?

Kiryll Prakapenka, Fat Tail Investment Research, 5 July 2023

Last week, I ragged on earnings per share (EPS). Today, I want to be more constructive. If we shouldn't rely on EPS for valuation, what should we rely on? If not EPS, then what? How about dividends?

Cash is fact, profit an opinion

Over three decades ago, economist Alfred Rappaport wrote the classic Creating Shareholder Value. In it, Rappaport wrote that cash is a fact, profit an opinion.

So if cash is more informative than earnings, how can investors use cash flows to improve their stock analysis?

A hasty way is to overcome the unreliability of EPS by tethering earnings to cash flow. Anchor earnings to cash and see if you can spot any suspicious divergence. High profits and a low tax charge may mean that profits are not what they seem.

We can go beyond using cash flows as a check on earnings, however. Cash can be used as the key input to value stocks.

Dividends as proxy for cash flows and value

If cash is a better measure than EPS, we can use dividends per share (DPS) as a proxy for cash flow.
After all, what are dividends if not a company's cash flow accruing to shareholders?
One way to value a stock using dividends is via the dividend discount model (DDM), which calculates the sum of the present value of all future expected dividends issued to shareholders.

The DDM has the following formula:

Stock price = DPS/(r - g)

In the formula:

DPS = expected dividends per share a year from now. r = required rate of return for investors/discount rate.
g = stable, long-term dividends growth rate.

Commonwealth Bank example

Let's use Commonwealth Bank of Australia [ASX:CBA] as an example.
CBA's FY24 DPS is expected to be $4.36 a share.

Using a discount rate of 8% and a (high) stable growth rate of 5%, we get a valuation of $145 a share, well overshooting the current price of around $102. I won't be rushing to buy CBA shares just yet, though. A growth rate of 5% seems excessive for a mature firm like CommBank.

We can work backwards using the formula to figure out what the market's implied growth rate is for the bank:

$102 = $4.36/(8% - g)

Solving for g gets us a stable growth rate as implied by the current price of about 3.7%. More reasonable, but still a bit of a stretch given the lower growth of the Australian economy.

A stock's stable growth rate has to be less than or equal to the growth rate of the economy in which it operates. In the May Statement on Monetary Policy, the Reserve Bank projected GDP growth to be below 2% well into 2025.

Using 2% as a stable growth rate, we get a valuation for CBA of around $73 a share. Using a growth rate of 3%, we get $87.

Clearly, the model is highly susceptible to suggestion. (But the more down-to-earth growth rates do seem to hint the bank's valuation is stretched). Tweak a key input like the growth rate, and the valuation fluctuates.

Pitfalls of the dividend discount model

The dividend discount model has great intuitive appeal. And it references cash flows (via dividends) instead of earnings!

Surely, it's the perfect measure of a stock's value then, right?

Unfortunately, nothing is so straightforward in investing. The model has its downsides. The biggest, already mentioned, is the sensitivity to assumptions.

Reference no: EM133632137

Questions Cloud

Reflect on the benefits and limitations of the methods : Create a slide deck in class that represents a portfolio of analytics methods used in accounting, economics or finance. This task is to be done as an individual

Develop a comprehensive report to a ceo : Develop a comprehensive report to a CEO. The task is to analyze the company (Tractor Supply Company) in this context and provide recommendations.

What do you think about the concept of investing : What do you think about the concept of investing in your A players more than other employees? Is it still relevant in today's business environment?

The employee was fired from the job because her productivity : The employee was fired from the job because her productivity did not show any improvement even after undergoing treatment for drug use

How can investors use cash flows to improve stock analysis : So if cash is more informative than earnings, how can investors use cash flows to improve their stock analysis - High profits and a low tax charge may mean

Explain what you learn from these verbal and nonverbal cues : Explain what you learn from these verbal and nonverbal cues. Include an explanation of how they influenced the effectiveness of the meeting.

Should credit rating agencies be regulated : Should credit rating agencies be regulated? Has globalization created the ineviatability of global contagion in financial crises?

How do accounting ratio compare relative to banking industry : How do the accounting ratios (book returns) compare relative to the banking industry? How your bank has stacked up against other banks in recent years?

Shelters for victims of domestic violence : Shelters for victims of domestic violence are also organizations greatly concerned with the security of their guests and staff.

User Account

All Pages