Why does the share have a certain value?

Posted by in Finance

A common question is why the shares on the stock market costs the way they do.

Answer: The price is based on the future dividends expectation from the company.

—”What? But the dividend is so low and I don’t think that this is true. The price is much higher than any dividends I’ll get from it. And what about when companies doesn’t pay any dividends at all? Especially certain tech companies. How can they have that value without dividends?”

First, let’s clear out what a dividend is. It is a payout from the company to shareholders. Since shareholders has a residual claim, which means that shareholders owns everything that’s left after all debt liabilities (bonds, bank loans) are paid out, it means that the money that is left after could potentially be paid out to the shareholders. The entire sum isn’t paid out though, because of many reasons. One is that the company may want to fund new projects first, and simply because paying out all in a dividend would make the shareholders pay a lot of tax (depending on their country of residence and domestic tax laws).

The company usually follows a passive residual dividend policy. It means that it follows a certain pattern. One other reason is that shareholders may have different consumption preferences. Some may like to have a large dividend and some like less (because the value of the share will then be higher). It all depends. So we can assume that the best dividend policy (how much to pay out as a return to shareholders) is to follow the same kind of pattern and not change too much. If a company is changing, it means they are signalling something with the dividend. Paying out a lower dividend could signal that they have interesting projects that needs funding or would make less profit, paying out a higher dividend could signal that they don’t have enough new innovative projects with positive NPV to fund and that the market is stabilizing (less growth).

Back to the price. Let’s say a company decides that the dividend for next year should be 10. How to calculate this?
The actual formula is P0=D1/(r-g). Wow. Nice one. P0 is “Price year 0” (now) . D1 is “dividend year 1” (next year). This is then divided by the r “required rate” minus g “growth”. Let’s say the required rate is 10%. Let’s say that the company expect to grow their dividend with 3% every year. To determine the price of the share, this is now calculated 10/(0.10-0.07)=142.85. This is a perpetual calculation. It means it goes on forever. No company will live forever but if you give me the benefit of the doubt, I will show why this is the case. The value 142.85 is the present price (today) of all future dividends.

Let’s do something crazy. Let’s calculate how much dividend you will get per year for the next 50 years and see how much we are off on the calculation.
As you can see on the “manual” calculation (Google Sheets) below, the exact value of all the future dividends is 137.52. This is (137.52/142.85) 96.2% correct. Pretty good guess then – also taking in consideration we are only going 50 years in the future – not 100.

Keeping this example in mind – another very interesting conclusion can be drawn. Look at the 8 years mark. How many % of the total share price valuation has been earned after 8 years? Only 42.49%! This is interesting. It shows that the stock market is long-term. Not short-term. Looking at 5 years it’s only 29% and looking at 20 years shows only 75.99% of the total stock value. So after 20 years of owning the stock you still haven’t been able to get it’s full value in dividends, including expecting growth for the dividend.

So, what about Tech companies like Facebook, Twitter and LinkedIn? How do they manage 0 dividend and still have a high value? Well, first of all they are in a growing market and they are completely equity financed (to avoid financial stress, which you get if you can’t pay your debts, provided you have debts). Even though they are not paying out any dividend, the price is based on the assumption of a dividend. Sounds weird? Risky? One could argue any way they want but the fact is that the market has priced the shares this way for a reason.

This was a short post about a huge subject.