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Thursday, August 10, 2006

What is a Stock Worth? Part 3 – Sources of Cash Flows

By William Trent, CFA of Stock Market Beat

Part 3 of a series we originally wrote as a fill-in on Blueprint for Financial Prosperity.

In Part 1 we demonstrated how to calculate the future value of a dollar today, or the present value of a dollar in the future. In Part 2 we explained why investors in stocks want more dollars in the future than investors in bonds. Now we get to the nitty gritty: where do the dollars come from when you buy a stock?

The most common thing people look at is the company’s earnings, which can be divided by the number of shares outstanding to get Earnings per Share (EPS). Very often people refer to Price to Earnings (P/E) multiples when looking at stock values. The long-term average P/E multiple for the stock market (and also the present multiple) is about 16x. That means that a stock with $1.00 of EPS is trading, on average, for $16.00.

You can also turn the P/E multiple upside-down to get E/P, which is also called the earnings yield. Using the same example, a P/E of 16x equates to an earnings yield of 1/16, which equals .0625 or 6.25%. The Federal Reserve did a study one time that showed that the earnings yield on stocks has historically been followed the yield on 10-year government bonds.

At the very least, there is a basis for comparison. You can look at the 6.25% yield on stocks and compare it to the 5% yield on a CD to decide whether the extra return is worth the extra risk of owning a stock.

But didn’t we say that on average stocks have paid 4% to 6% more than risk-free assets? How can that be if the earnings yield on stocks is the same as the yield on bonds? The reason is that, in addition to any current payments, stocks also tend to grow in value over time. So the total return on the stock is the current yield plus any growth in the value of the stock over time. In essence, the Fed Model shows that it is that growth that compensates for the additional risk of stocks.

This brings us to the fact that earnings might not be the best measure of cash flow. If you buy a stock and the company earns $1.00 per share, they don’t give you $1.00. Usually they keep some or all of their earnings to invest in their growth. Even if you ask for it, they won’t give it to you. Even though by owning a share you are part-owner of the company and “entitled” to your fair share of the earnings. Although they can be useful when comparing the value of companies, or the ability of companies to grow and return money to shareholders, they might not be appropriate to determine the money a shareholder can expect to receive.

From the shareholder’s perspective, the two sources of cash flow from a stock are the growth in value and any dividends the company pays. Dividends are similar to the interest payments on a bond. They are usually paid out on a quarterly basis and quoted as an annualized yield. For example, Verizon pays out a dividend of $0.405 per share per quarter, or $1.62 per year. At the recent share price of $32.24 this equates to a 5.0% yield, similar to that available in government bonds.

So now we can get to the heart of what a stock is worth to an investor. It is the present value of all the dividends the shareholder will receive, plus the present value of whatever it will be worth when the investor decides to sell it.

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