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The Most Fundamental Way to Buy Stocks

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At its core, buying stocks is about trading the certainty of having cash today for the possibility of getting more cash back in the future. How much you wind up with is based more on these three key factors than any others:

  • How much you invest.
  • What rate of return you earn.
  • How long you stay invested.

The first and third are easy to understand and somewhat within your control. That second one, though, is tougher to predict. Over time, it depends on both how the company's business performs and how the market reacts to that performance. Neither of those is completely knowable in advance.

Back to basics
Over the years, many different ways to predict stocks' performance have come and gone. None of them are perfect, but one of them has the very cool twin benefits of being focused on cold hard cash and being stone cold simple. It's called the Gordon Growth Model, and it values a company's stock based entirely on the value of expected future dividends. In other words, for the cash you pay now, you get your possibility of more cash back in the future from dividends.

In its classic form, Gordon's model is used to figure out what a fair price for a company is based on its dividends, and its key equation gets written as P = D/(R-G). Those letters mean:

  • P is the fair value of the stock based on its future dividends.
  • D is the estimated dividend payment from the company over the next year.
  • R is the investor's required rate of return (sometimes called expected return).
  • G is the company's long-run dividend growth rate.

If you rearrange the formula to solve for "R", you wind up with R = D/P + G. In plain English, that means that by Gordon's model, your expected total long-run return on an investment is equal to the stock's dividend yield plus its long-term dividend growth rate. Stone cold simple meets cold hard cash. Pretty cool, eh?

Where it doesn't work
The catch, though, is that the there are plenty of places where Gordon's model will fall apart. For instance, if a company has erratic dividend payments like Annaly Capital Management (NYSE: NLY  ) , it gets hard to guess what next year's dividend will be or whether those payments will really grow over time.

Likewise, if a company just instituted its first ever dividend like Cisco Systems (Nasdaq: CSCO  ) recently did, it won't work there, either. After all, how do you peg a growth rate on a move from $0 to $0.24 in a year? And even if you could assign a growth rate to its dividends, Cisco may very well raise its payout faster than its "long term" rate over the next several years.

And of course, if a company pays no dividend, this model would call it "worthless." Warren Buffett and the other shareholders of Berkshire Hathaway (NYSE: BRK-B  ) would strongly object to characterizing that company as being worth $0. Looking only at its net tangible assets -- a shorthand proxy for its liquidation value -- Gordon's model undervalues Berkshire Hathaway by more than $100 billion. That's not exactly a rounding error.

Where it does work
That said, for stocks of companies with a very narrowly defined set of characteristics, Gordon's model can be very powerful, indeed. The companies have to:

  • Show sustained commitments to paying and raising their dividends. Current yields above 2% and annual raises of at least 5% over the past 10 years are signs of real commitment.
  • Protect themselves from the world's uncertainties. Debt to equity ratios less than two and payout ratios below 60% of earnings signal prudent financial stewardship.
  • Provide decent reasons to believe their business can be sustained. While this one is a bit tougher to quantify, it often becomes a case of "you know it when you see it."

Taken all together, you find rarefied companies like these suitable for Gordon's model:

Company

Current Yield

Minimum Dividend Increase Rate Over Past 10 Years

Average Dividend Increase Rate Over Past 10 Years

Implied Potential Long Run Return

Coca-Cola (NYSE: KO  ) 2.8% 7.2% 8.9% 10% to 11.7%
PepsiCo (NYSE: PEP  ) 2.9% 5.9% 9.8% 8.8% to 12.7%
United Technologies (NYSE: UTX  ) 2.1% 7.1% 12.9% 9.2% to 15%
General Mills (NYSE: GIS  ) 2.8% 8.6% 11.3% 11.4% to 14.1%

Source: Capital IQ, a division of Standard & Poor's.

In addition to hitting all the financial criteria, all four of those companies have strong, industry leading brands that people know and trust:

  • Coca-Cola has, well, Coca-Cola.
  • In addition to its namesake, PepsiCo also owns the Frito-Lay snacks business.
  • United Technologies is the home of Carrier air conditioners, Otis elevators, and Pratt & Whitney aircraft engines.
  • General Mills can lay claim to Cheerios, Pillsbury, and Green Giant.

Those powerful brands, combined with the companies' financial strength, provide much of the reason to believe their businesses can be sustained.

Financial comfort food
Best of all, even with those strict characteristics and small number of qualifying companies, Gordon's model does offer up opportunities that suggest decent long-term potential returns. And remember, those returns based entirely on the cash you expect to receive in your pocket from dividends. With that in mind becomes apparent that you can still benefit from focusing on fundamentals when buying stocks.

At the time of publication, Fool contributor Chuck Saletta owned shares of Annaly Capital Management. The Fool owns shares of Annaly Capital Management, Berkshire Hathaway, Coca-Cola, and PepsiCo, and has created a bull call spread position on Cisco Systems. Motley Fool newsletter services have recommended Berkshire Hathaway, Coca-Cola, Cisco Systems, and PepsiCo, as well as recommending creating a diagonal call position in PepsiCo. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.


Read/Post Comments (6) | Recommend This Article (13)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On May 17, 2011, at 6:27 PM, WBRWBR wrote:

    Take another algebra class. When you solve for R, it is:

    R = (D+PG) ÷ P

  • Report this Comment On May 17, 2011, at 6:49 PM, pbk100 wrote:

    Continue that thought, WBRWBR,...

    (D+PG)/P = D/P + PG/P

    = D/P + G

    which is what he said.

  • Report this Comment On May 17, 2011, at 9:19 PM, TMFBigFrog wrote:

    Hey Fools:

    Here's the chain of algebra to get from Gordon's representation to mine:

    P=D/(R-G)

    (R-G)*P=(R-G)*D/(R-G)

    (R-G)*P=D

    R*P-G*P=D

    R*P-G*P+G*P=D+G*P

    R*P=D+G*P

    R*P/P=(D+G*P)/P

    R=D/P+G*P/P

    R=D/P+G

    And of course, D/P = Dividend / Price = Yield.

    As such, by Gordon's Model:

    Expected Return = Yield + Dividend Growth

    Hope this helps. Happy to talk more.

    -Chuck

    Inside Value Home Fool

  • Report this Comment On May 17, 2011, at 9:45 PM, DonkeyJunk wrote:

    WBRWBR = pwn

  • Report this Comment On May 18, 2011, at 10:37 AM, dan1liy wrote:

    ""D/P= Dividend/Price=Yield""

    Are you doing an assumption that "P" is a market price in calculating Div. yield?

    "P" should be an estimated value of stock based on future dividends. And it is not always equivalent to what market pays for stock.

    Correct me if I'm wrong.

  • Report this Comment On May 18, 2011, at 8:26 PM, TMFBigFrog wrote:

    Hi dan1liy,

    Great question. In reality, it depends what you're solving for in the equation and/or what you're looking for from your decision aid.

    You can rearrange the terms of Gordon's equation any way you want and put your assumptions in it as you see fit, depending on the qustion you're trying to answer. What's most important is that you are able to justify the inputs in your model.

    Because no matter how good the model, if you feed it bad information, you'll get a bad outcome from it.

    Regards,

    -Chuck

    Inside Value Home Fool

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Chuck Saletta
TMFBigFrog

Chuck Saletta has been a regular Fool contributor since 2004. His investing style has been inspired by Benjamin Graham's Value Investing strategy, and he manages the real-money Inflation-Protected Income Growth portfolio on Fool.com based on many of Graham's principles. Chuck also can be found on the "Inside Value" discussion boards as a Home Fool.

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