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Saturday, October 3, 2009

Cash Flow Generating Securities

One of my personal favorites is calculating the Net Present Value/Breakeven point for a stock that pays a stable dividend stream. This metric actually has relevance because the dividend is a cash payment that comes directly to the investor as a consequence of owning the shares. In the short-term, dividends are a known quantity. Obviously the metric only applies in the case where a dividend is paid. In the case where an investor is focusing on dividend investing for income purposes or simply for generating the maximum cash from their investing capital, these are important considerations.

An example is on order. Let’s say that an investor purchases 100 shares of a stock trading at $10/share that pays a $1/share annual dividend. The dividend yield on his investment is 10%. The P/Div ratio is 10. This means that the investor paid $10 for every dollar in dividends. Now the nice thing about dividends is that they are cash streams and we can use some common time value of money calculations to make determinations as to whether or not to invest. Let’s use the 100 shares as an example and do a net present value calculation with the following assumptions:

•Our time horizon is 25 years
•Dividends over the 25 years will average the current $1/year
•The Cost of Capital (COC or inflation) will be 6%/year for the duration of the exercise
Most popular spreadsheet programs contain the NPV function where you can set your COC and the value of the individual cash flows if you desire to perform this analysis for yourself.

The Net Present Value of this situation is $262.58, giving a positive indication or a ‘buy’ signal. This alone should not be used to make a buy determination, but should be used as a tool to validate or invalidate individual investment opportunities that arose from our analyses in parts I and II.

The Time to Cover or Breakeven point of this hypothetical investment is Year 15. What this means is that after 15 years, the dividends (after accounting for the deterioration in value due to inflation) will cover the cost of the initial investment. Whatever the investment itself is worth at that time is added value. So even if our stock is still at $10/share, it is paid for, we’re in the clear, making dividends for another 10 years before we need the funds, and can sell the stock at any time thereafter for a pure profit. And since inflation has already been figured in, we’re talking about real gains. We can easily modify the analysis to accommodate hypothetical taxation circumstances as well. Another important point may also be made from the above analysis. Considering that we’re getting $1/year in dividends, in nominal terms, the Time to Cover/Breakeven would be 10 years. Inflation at a rate of 6% per annum increased the breakeven point by 50% or 5 years. While 6% doesn’t seem like that much, this example illustrates exactly how much of a burden on wealth it represents. If anyone really wants to see why clipping bond coupons isn’t such a hot idea, run this analysis on the 30-year Treasury Bond and it will become immediately obvious.

Moving forward, when looking at dividend paying investments, we are looking for lower P/Div ratios (higher yields), and consequently lower Time to Cover/Breakeven points. While looking at the yield gives some good insight, using the NPV and breakeven analysis allows us to quantify the deleterious effects of inflation over time. The yield alone doesn’t give us that ability since it is a snapshot in time and changes as the price of the underlying security changes. It is important to note that in this study, we are NOT valuing the firm. We are valuing the cash streams that the firm pays to shareholders and discounting them to the present.

The risks to the above analysis are obviously many. 25 years is a long period of time, and things can change dramatically. Firms can go out of business or eliminate dividend payments thereby rendering the above effort worthless. Also, the major types of risk such as market, currency, political, and systemic cannot be accounted for over such a long period of time. This is one of the reasons why it is never a good idea to buy today and walk away. Successful investing is a journey, not a destination. As soon as you think you’ve got it all figured out, that is when you’ll get bitten. Vigilance is the name of the game. Another obvious takeaway here is that we’re dealing with long term investing, not trading. Such studies are a moot point for the short-term trader since their focus is on a different goal. Realize I am not trying to be impertinent towards traders, but simply pointing out the difference between their objectives and those of long-term investing.
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