How do you apply dividend irrelevance theory to value a growth company?

For a privately-held company, the payment of steady dividend distributions would tend to decrease the discount for lack of marketability (all other things equal), as the dividends enable the investor to get one's capital back over time, resulting in a higher value for the shares. In addition, it is my observation that steady dividends tend to reduce the volatility of a publicly-traded stock, as the dividend signals the ability to deliver consistent excess cash flow. Of course, if an investor is interested in high growth above all, such considerations become less important.

One of these wonderful theories that doesn’t work in real life, like the efficient markets theory for example. Dividends are not irrelevant for many classes of investor and have one fundamental quality not shared by capital gain - once paid out, they cannot be taken away.

To assess a growth company through the lens of the dividend irrelevance theory, it's necessary to first calculate the earnings growth rate. This calculation gives an insight into the company's capabilities to consistently generate profits and reinvest them effectively into lucrative projects. To undertake this calculation, one may employ the use of historical company data, encompassing the trends in revenue and net income over time. Furthermore, insights can be gleaned from external factors, such as overall economic health and industry-specific trends in growth. On the other hand, future projections through forecasting models can assist in predicting the possible trajectory of earnings, making them a valuable resource for this calculation.

Exploring the application of the dividend irrelevance theory in valuing growth companies is truly fascinating. Rather than solely focusing on dividends, this theory emphasizes the importance of a company's investment decisions and its overall earnings potential. By considering factors such as future cash flows and growth prospects, we can paint a comprehensive picture of the company's value, even in the absence of dividends. This approach allows us to better understand the dynamics of growth-oriented firms and tailor our valuation methodologies accordingly.

Computing the Compound Annual Growth Rate (CAGR) is one way to estimate the earnings growth rate. It provides a clear picture of the historic performance of the company by smoothing out outliers in performance. This rate is helpful in forecasting future earnings.

The second crucial step is to gauge the required rate of return, indicative of the minimum return that investors anticipate when sinking their capital into a company's investment opportunity. Investors' required rate of return often mirrors the risk inherent in the investment and the alternative opportunities they have foregone, subsequently determining the cost of capital for the company. The Capital Asset Pricing Model (CAPM) provides a robust method to calculate this rate, incorporating the risk-to-reward trade-off pertinent in the investment.

I have found the capital asset pricing model (CAPM) to be relatively reliable in my experience. There have been a lot of criticism on market performance being the only factor to affect a company's stock performance. However, I believe that a rational investor must diversify his/her investments to take care of firm related risks. I place a lot of value on CAPM as it is an easy and functional model.

The required rate of return is the minimum return that an investor is expecting to receive for their investment considering the risk level of the investment. I personally use Capital Asset Pricing Model (CAPM) for calculation of the required rate of return as it is more reliable and easy to compute.

Finally, the constant growth model uses these indicators to estimate the intrinsic value of a growth company, presenting a simplified variation of the dividend discount model. As the name suggests, this model works under the assumption that a company's earnings and dividends grow at a steady rate indefinitely. In the absence of a significant dividend payout, the company's intrinsic value per share is determined by the current earnings per share, the required rate of return and earnings growth rate. Through these figures, the constant growth model substantiates that a company's value remains unchanged irrespective of its dividend policy.

The constant growth model might seem elegant in theory, but applying it to a growth company is like using a straightjacket on an athlete. This model assumes perpetual stability, which contradicts the very nature of high-growth firms characterized by rapid and unpredictable changes. Warren Buffett cautions, "The investor of today does not profit from yesterday’s growth." Instead, adapt the model to incorporate fluctuating growth rates, recognizing the dynamic evolution of the company's value. Flexibility in your valuation approach mirrors the agility needed for growth companies to thrive.

I believe using the CAGR will take out the need to use the multi-stage model for a mature company. My reason being that the CAGR smooths out the earnings rate which can then be applied to estimate the value of the company. In estimating the CAGR over a long period, you take the company's performance in both eventful and non-eventful periods into account. I would also advice to make reasonable assumptions when estimating the non-constant growth rate.

Have in mind that each valuation has premisses and problems. For instance, Income Approaches tend to use highly sensitive premisses in order to reach into a valuation. Whereas, Market Approach has a high dependancy on comparables - think about trying to compare Tesla and Ford. Both are automakers, however their profile differs a lot. While Cost approach tends to be outdated as few lines are updated up to market value on the books. The best comparison is the one that mitigate and minimize all those pitfalls.

When comparing the value per share derived from the dividend irrelevance theory with other valuation methods, it's crucial to recognize that each approach has its strengths and limitations. The DCF method, for instance, provides a comprehensive view by incorporating future cash flows and risk factors, while the multiples method offers a market perspective that can highlight relative valuation discrepancies. Market conditions and investor sentiment can significantly influence valuations, making it essential to consider these external factors. A multi-faceted approach that integrates various methodologies will yield a more robust and accurate valuation, particularly for growth companies where dividends may not be the primary focus.

Valuation isn't just about numbers; it's an art intertwined with intuition and foresight. Beyond financial metrics, consider the company's innovation pipeline, market disruption potential, and the visionary leadership steering it. Steve Jobs famously said, "Innovation distinguishes between a leader and a follower." Ignoring these intangible yet pivotal factors can result in a myopic valuation. Acknowledge the broader narrative that encompasses a company's essence, and your valuation will resonate with deeper insights and foresight.

It's essential to recognize that dividend irrelevance theory posits that a firm's value is determined by its earning power and risk, rather than its dividend policy. This perspective is particularly relevant in today's market, where many high-growth companies reinvest profits rather than distribute dividends. Analysts should focus on robust growth projections and the sustainability of those earnings. Incorporating scenario analysis can provide deeper insights into potential future valuations, allowing for adjustments based on varying growth rates and market conditions.