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When using dividend valuation models the most influential variable, and the one subject to most uncertainty, on the value of shares is the growth rate expected in dividends. Accuracy here is a much sought-after virtue. While I cannot provide subscribers with perfect crystal balls for seeing future dividend growth rates, I can provide a few pointers.
Determinants of growth
There are four factors which influence the rate of dividend growth.
1 The quantity of resources retained and reinvested within the business This relates to the percentage of earnings not paid out as dividends. In general, the more a firm invests the greater its potential for growth. But, as you’ll find in investing, many directors invest in industries and projects they are familiar with regardless of whether a positive return is generated – very irrational, but it can be observed over and over again, which leads on to the next point.
2 The rate of return earned on those retained resources The efficiency with which retained earnings are used will influence value.
3 Rate of return earned on existing assets This concerns the amount earned on the existing baseline set of assets, that is, those assets available before reinvestment of profits. This category may be affected by a sudden increase or decrease in profitability. If the firm, for example, is engaged in oil exploration and production, and there is a worldwide increase in the price of oil, profitability will rise on existing assets. Another example would be if a major competitor is liquidated, enabling increased returns on the same asset base due to higher margins because of an improved market position.
4 Additional finance In addition to using retained earnings, investment funds can be raised and future value can be boosted just so long as the firm has value enhancing projects. The new shareholders and debt holders will not take all the additional value (usually) and so returns to existing shareholders can be raised.
There is a vast range of influences on the future return from shares. One way of dealing with the myriad variables is to group them into two categories: at the firm and the economy level.
Focus on the firm
A dedicated analyst would want to examine numerous aspects of the firm, and its management, to help develop an informed estimate of its growth potential. These will include the following.
1 Strategic analysis The most important factor in assessing the value of a firm is its strategic position. The analyst needs to consider the attractiveness of the industry and the competitive position of the firm within the industry to appreciate the potential for increased dividends
2 Evaluation of management Running a close second in importance for the determination of a firm’s value is the quality of its management. A starting point for analysis might be to collect factual information about the key managers and their level of experience (particularly longevity with the company) and of education. But this has to be combined with far more important evaluatory variables which are unquantifiable, such as judgement, and even gut feeling about issues such as competence, integrity, intelligence and so on. Having honest managers with a focus on increasing the wealth of shareholders is at least as important for valuing shares as the factor of managerial competence. Investors downgrade the shares of companies run by the most brilliant managers if there is any doubt about their integrity – highly competent crooks can destroy shareholder wealth far more quickly than any competitive action:. (For a fuller discussion of the impact of managerial competence and integrity on share values seeArnold (2009) The Financial Times Guide to Value Investing.)
3 Using the historical growth rate of dividends If a company
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