How to Value Equities - The Discounted Cash Flow (Dividends) way! - Example:SingPost

A reader asked us to write about valuing equities using the Discounted Cash Flow method sometime back. It has been long overdued...sorry dude or duddette...we have been busy analysing some stuff of late. Before you read on, we would like to mention that this method entails a lot, a lot and we mean a lot of assumptions and it is highly theorectical. Garbage in- garbage out. Why do you think Research Reports target prices are nearly always way off target? Anyway, its the thought process that counts and not the final target price. Who knows, when thinking through the process..you may actually gain insights on the stock you are researching. So its not useless..this model.

There are many forms of DCF analysis and we will be looking at discounting dividends. This is most appropriate for valuing stable companies (for example in a mature industry) and those that have a consistent payout of dividends . (Please note that there are other types such as discounting Operating Free Cash flow or discounting Free Cash flow ).We will be using SingPost as an example. See below for the yearly dividends they give out. We started from year 2006.

Based on the table above, it is logical to assume that they will be giving out at least S$0.0625 in dividends every year from 2009 and beyond. So here comes the DCF formula. Its looks ugly but its actually quite easy. SGDividends will walk you through.

Figure 1

The foundation of this formula is that the value of a asset ( stock in this case) is the present value of its expected future cash flows ( dividends in this case). In the above formula, it is taking all the dividends up to infinity years ahead and bringing it back to the present value, now. People then compare this present value now with the current stock price to see if its cheap or not. The dividends for a company could grow in time, therefore, the variable g takes into account the dividends growth.
As SGDividends is all about making complicated things even easier than easy. We are going to derive a formula which will be easier than easy to use. The derivation is below in figure 2, but you can skip this part amd jump to the final formula in Figure 3.

Figure 2

You can read up on the sum of infinity through thislink. From the above maths in figure 2, we derive the following formula in figure 3 from the equation in figure 1. Isn't it much easier to use now?

Figure 3

So let's put all this mumbo-jumbo in practice, shall we?

For Singpost:

Dividends for current period ( or most recent period) , Do= S$0.0625.

As it is in a mature industry, assuming dividends is growing slowly at a rate, g = 2%.

Let's assume your required rate of return, K = 6% ( We use 6% just to follow the rate from DBS preferential shares. It can be anything you wish because its YOUR required rate of return.Most people would then choose as high a rate of return as possible as more is better right?Then its wrong. You should consider your required rate of return as the rate of return of the next best investment which you think you can get. So if you thought DBS preference shares at 6% is one of the best around or it makes you happy, then use it as a benchmark to input the K.)

Value of stock = [0.0625(1+0.06)] / ( 0.06 - 0.02) = $1.65625

Price currently as of 21 Nov 2008 as listed on SGX = $0.76.

Don't go rushing to buy this stock yet as we have said before there are many assumptions. Firstly, there is no guarantee that Singpost will continue giving out dividends or dividends will grow. There is no guarantee that Singpost will last forever, it might go bankrupt like Ferrochina ( haha...do you think so?). If Singpost decides to be crazy and start giving out more dividends than is manageable to its survival as a company, then of cos using the model doesn't work as it will not last and the current value you calculate will be too big and wrong. It is theoretical and also you will realise that this is not appropriate for all companies, since some companies don't give out dividends.

Important: The objective of the articles in this blog is to set you thinking about the company before you invest your hard-earned money. Do not invest solely based on this article. Unlike House or Instituitional Analysts who have to maintain relations with corporations due to investment banking relations, generating commissions,e.t.c, SGDividends say things as it is, factually. Unlike Analyst who have to be "uptight" and "cheem", we make it simplified and cheapskate. -The Vigilante Investor, SGDividends Team

What should i invest now? Get real confused by following the Gurus!

See below for the current portfolios of investing GURUs. Warren buffet, Boone Pickens and George Soros. Each is regarded as having been successful in investing and experienced ( read: old) enough, having been through market ups and downs to be considered credible in their stock selection. But alas, just look at their porfolio allocations and at first glance, be terribly confused .Warren Buffet seems to be underweight in Oil & Gas, but Boone and Soros is overweight in these. Warren Buffet seems to be overweight in consumer goods ( staples) but Boone and Soros are underweight. Look at the finance allocation and you will again see the difference. So, who should we follow? (of cos follow SGDividends portfolio lah...we overweight in utilities but the GURUs underweight in it!Shiok.....just joking, don't follow us pls, use your own brain..)

George Soro's Portfolio

Boone Picken's Portfolio

Warren Buffet's Portfolio

Actually when we think further, it kinda makes sense to us. The reason for the seemingly stark difference especially between Warren and the other 2 could be due to the time horizon and investment philosophy. Warren Buffet did say before he goes for value companies which just happen to appear more often in bad times. Boone and Pickens could be those who times the market and they are making a bet that Oil & Gas, will make a comeback which we think so too...its just basic economics of limited supply and increasing demand. And think of it, do you think OPEC will let the price fall too much? Come on.....

SGDividend's portfolio ( Singapore and foreign shares)

Anyway, above is our humble portfolio currently. We overweight on Telecommunications and Utilities due to its near recession proof demand due to them being considered necessities. Also they give stable dividends during this time. We keep some in Oil & Gas and basic materials ( include agriculture) as we believe it will rebound, not in the near term though....maybe in at least 1 years time...We are also moderstely overweight on Industrials especially those whose business have some sort of recurring income and are exposed to Infrastructure spending. We slightly underweight healthcare cos we don't think it has much scope for future expansion ( as compared with the other sectors)chiefly because its labour intensive. Property is obvious not the time to move in yet...lah. Wait for much more retrenchments. We are waiting for some banks to follow DBS!And then once banks have taken the lead...............................................

Anyway the morale of the above story is......have your own view as everyone is different!And that's why there is a market!

Important: The objective of the articles in this blog is to set you thinking about the company before you invest your hard-earned money. Do not invest solely based on this article. Unlike House or Instituitional Analysts who have to maintain relations with corporations due to investment banking relations, generating commissions,e.t.c, SGDividends say things as it is, factually. Unlike Analyst who have to be "uptight" and "cheem", we make it simplified and cheapskate. -The Vigilante Investor, SGDividends Team