Response to Chuzzlewit 11/16/99
Thanks for taking the time to critique my procedure for finding what a stock is worth. Let me suggest an alternative way to view that procedure because it leads to a valuable outcome.
I agree that the value of a stock is the present value of future cash flows. I am interested in what the stock is worth to me, not to anyone else. So I want the present value of the net cash that flows into my pocket. Those flows are dividends and the net proceeds when I sell, which flow into my pocket, and taxes and broker's commissions, which flow out. I therefore need to forecast dividends and the price of the stock when I sell to find what any stock is worth to me.
I know that stockholder equity is an accounting fiction. But it is a useful fiction. It is useful because everything I want to know -- earnings, dividends, and stock prices -- are related to equity/share. Once I forecast equity/share forecasting earnings, dividends and stock prices is much easier.
Equity/share is not difficult to forecast. I know the current equity/share. There is a historical record of the growth rate of equity/share. I can also make a judgement about the firm's future. That gives me a basis for forecasting future growth rates. I do not have to forecast that the growth rate stays constant. If growth is now rapid, the most reasonable forecast is that growth will gradually slow rather than stay at today's high rate forever. I prefer to forecast by drawing a free-hand curve on a sheet of graph paper. Free-hand curves provide the ultimate in flexibility for forecasting how growth will gradually slow as a growth firm matures.
Once I forecast growth rates, I have implicitly forecast future values of equity/share. I have developed a simple way to translate the growth rate forecast into the corresponding forecast of equity/share at any point in time.
The next step is to forecast the return on equity. I can then simply multiply the forecast of equity/share at any point in time by the forecast of return on equity at that point to develop a forecast of earnings.
Once I forecast the growth rate and the return on equity, I have also implicitly forecast the dividend payout fraction. The dividend payout fraction is 1.0 minus the ratio of the growth rate to the return on equity. Multiply the earnings forecast by the dividend payout forecast and you have the forecast of dividends.
The procedure for forecasting future stock prices is simple. Forecast the price/book ratio.Then multiply the forecast of equity/share at any point in time by the forecast of the price/book ratio at that time. I also draw a free-hand curve to forecast the price/book ratio. That makes the forecast stock price change gradually. The stock price does not suddenly drop, as you suggested.
These forecasts tell me the net cash that will flow into my pocket. Discount at the minimum rate of return I will accept, and that is what the stock is worth to me.
I recognize that the market price is different. That is not a problem. I am not calculating the market price, I am calculating what the stock is worth to me. If the market price is higher than the value I calculate, the stock costs too much, at least for me. If the market price is close to the value I calculate, the stock is fairly priced. And if the market price is lower, the stock is a buy.
John Malloy |
