How to Value Equities - The Discounted Cash Flow (Dividends) way! - Example:SingPost

A reader asked us to write about valuing equities using the Discounted Cash Flow method sometime back.

There are many forms of DCF analysis and we will be looking at discounting dividends. This is most appropriate for valuing stable companies (for example in a mature industry) and those that have a consistent payout of dividends. We will be using SingPost as an example. See below for the yearly dividends they give out. We started from year 2005.

Based on the table above, it is logical to assume that they will be giving out at least S$0.0625 in dividends every year from 2009 and beyond. So here comes the DCF formula. Figure 1

The foundation of this formula is that the value of a asset ( stock in this case) is the present value of its expected future cash flows ( dividends in this case). In the above formula, it is taking the present value of all the dividends up to infinity years ahead and bringing it back to the present value, now. People then compare this present value now with the current stock price to see if its cheap or not. The dividends for a company could grow in time, therefore, the variable g takes into account the dividends growth.

SGDividends is going to derive a formula which will be easier than easy to use. The derivation is below in figure 2, but you can skip this part and jump to the final formula in Figure 3.

Figure 2

You can read up on the sum of infinity through thislink. From the above maths in figure 2, we derive the following formula in figure 3 from the equation in figure 1. Isn't it much easier to use now?

Figure 3

So let's put all this in practice, shall we?

For Singpost:

Dividends for current period ( or most recent period) , Do= S$0.0625.

As it is a mature industry, assuming dividends is growing slowly at a rate, g = 2%.

Let's assume your required rate of return, K = 6% ( We use 6% just to follow the rate from DBS preferential shares. It can be anything you wish because its YOUR required rate of return.)

Value of stock = 0.0625 / ( 0.06 - 0.02) = $1.5625

Price currently as of 21 Nov 2008 as listed on SGX = $0.76.

Ok the formula should be Do (1+K) / (k-g).
So the value should be 1.65.
[0.0625(1+0.06)] / ( 0.06 - 0.02) = $1.65625

Don't go rushing to buy this stock yet as we have said before there are many assumptions. Firstly, there is no guarantee that SingPost will continue giving out dividends or dividends will grow. There is no guarantee that SingPost will last forever. It is theoretical and you will realise that is not appropriate for all companies, since some companies don't give out dividends.