A Short Essay on Valuation

Fellow shareholders, let me tell you one of the best-kept secrets of the stock market: We cannot earn more money from our investment in a company than the cash that the company pays out to us (mostly dividends and eventually some liquidation value) over its remaining lifetime.

How could it be otherwise? No company lives forever. The profits it generates are valuable to us only if they get paid out to us before the company's stock price hits zero. Reinvestments, share buybacks, mergers and acquisitions, spin-offs etc. have zero value for shareholders if they do not lead to higher cash payments per share in the future.

There is no way around this basic fact of shareholder life, yet it is ignored by most market participants and commentators most of the time. Believe it or not, most of them have never even thought about this!

Just because you can trade any given stock at any given time in a liquid stock market does not change anything about this logic. If you sell your stock at a higher price than would be justified based on the cash that the company pays out after your sale, you have simply taken a bite out of the piece of the cake of your fellow shareholders. Vice versa, if you sell too cheaply, your fellow shareholders will earn correspondingly more (though, because of several fee layers, less than what you have missed out on).

Nobody knows the exact amount of dividends that a company will pay out during its lifetime. Enter discounted cash flow valuation. The future is what matters. And it is unknowable. Competence and probability theory help us deal with this uncertainty. While different people apply different assumptions regarding a company’s earning power, its reinvestment rate, its return profile and the right level of discount rate, discounting the future to the present and making competent assumptions about what enters this calculation is the only rational way of how to value future dividend payments. After all, a Swiss franc tomorrow is worth less than one today. And today and tomorrow are linked via probabilities.

This does not mean, however, that the price at which shareholders are willing to buy and sell a given stock is always rational. Quite to the contrary, clearing prices depend on many other factors such as, for example, institutional incentives, leverage constraints and individual and mass psychology. The market therefore does not always get it rationally right. Enter value investing. Value investors focus on discrepancies between rational values and irrational prices. Despite many assurances to the contrary, I have not yet found any convincing evidence that this kind of thinking is out of date and doesn’t help investors make better decisions.

Nevertheless, the stock market prices equities quite rationally. Take Nestlé. Its earning power and return profile are well known and its management team can be counted on the either reinvest excess cash profitably or pay it out to shareholders. The company currently trades at 26 times 2020 earnings (not just dividends), implying a discount rate of a little under 4%. The return on 10-year Swiss government bonds currently stands at a little below 0%, implying a risk-premium of around 4%, close to its long-term average and a level that doesn’t strike me as obviously irrational (though it might well be a little lower than that). After all, owning an individual stock should be somewhat riskier than owning debt of a solvent government that can print the currency with which it will pay you back, right?