This article was originally published on Oct. 4, 2004.
After Book Value Bargains was published, my email overflowed. Those not offering to enhance body parts were asking, "How does a value investor decide to sell a stock that has now risen above book value?"
In truth, I think book value serves a limited purpose for an investor. I believe that virtually every operating company that is both profitable and a going concern deserves to be valued at least at its book value. Beyond that, I pay very little attention to book value. Instead, once such a company surpasses book value, I switch to an operations-based valuation metric for investing purposes.
I prefer the classic valuation methods described by the dividend discount model (DDM) and the discounted cash flow (DCF) model. Both models define the value of a stock as the net present value of expected future cash flows to shareholders. Both attempt to consider a company as being worth precisely what it expects to earn or pay out over its future, with those payments reduced by a time and risk factor to an appropriate value for today. The major difference is that DCF models essentially value potential dividends, while the DDM values only actual dividends.
At first glance, the notion of valuing cash that you don't really get might seem strange, but the DCF model is actually the more versatile of the two models, as it can be used to value the vast numbers of companies that pay little or no dividends, or whose incipient dividend policies make their dividends unpredictable. For example, Microsoft
DDM, not DOA
But for companies that tend to pay substantial, predictable dividends, such as financials, REITs, pipelines, and stable, maturing giants, the DDM is the better model, at least in my book, as it sidesteps the abstract assumption of shareholders "owning" cash that they don't actually receive. Plus, for these companies, dividends tend to be much more stable than the income figures on which DCF analysis is based.
That stability helps with projections -- and projections are really the core of both models. Still, nothing's certain, so the best any of us can do is estimate. For dividends, we might start by considering past trends, and then add any other information that might cast light on a company's dividend future. Looking at the Book Value Bargains' subject Presidential Life
Until the company's business started slowing around 2000, it had been aggressively raising its dividends. Those hikes occurred before the dividend tax cut, which signaled to me a commitment by management to reward investors for the financial risks associated with investing in the company, not just a short-term response to tax law changes. Years 2001 and 2002 were bad for the company, which excuses the unchanging dividend in my mind. And presuming that 2003 and 2004 were rebuilding years, I will forgive the static dividend during that period as well. For my account, however, Presidential Life will remain a compelling investment only if it resumes raising its dividends now that its financials have improved.
The company can't indefinitely sustain dividend increases at the rate it had been from 1995 to 2000. Over the long haul, companies don't grow faster than nominal economic growth (inflation plus real growth), lest they overtake the entire economy. Presuming 3% inflation and 3% real growth, I can't estimate faster than 6% perpetual dividend growth. In the shorter term, Presidential Life's 2004 results thus far have come in far ahead of 2003's, with revenues up 20% and earnings more than doubling in the first six months of the year. Most of that is due to gains in investment income, and it certainly won't continue forever.
The company had been raising its payout ratio before its business slowed. At 37% of 2003 earnings, and with 2004 earnings looking so much stronger, there looks to still be room to safely grow dividends without hitting unsustainable high levels. I will guess five years of 20% dividend growth, five years of 15%, five years of 10%, and then a perpetual 6% rate. The growth rate assumes both an increasing payout ratio to around 50% and growth in the company's earnings over time. Plugging the numbers and my 12% discount rate into a DDM calculation, my fair value estimate ends up as follows:
Some value investors believe that an investment should be bought at a discount and sold once it reaches fair value. I follow a different approach. My personal approach is to hold all my investments unless at least one of the following conditions applies:
I realize that I made a mistake in my analysis.
A company's fundamentals deteriorate such that it no longer looks capable of performing over the long haul at a rate that justifies its current price.
A company's price has run up to well beyond my estimate of fair value.
I have a better use for the money.
At a recent price of $16.92, Presidential Life is near my estimated fair value. As long as it performs to my expectations, I see no need to sell. Note that my estimate revolves around the presumption that the company will resume growing its dividends shortly. If that growth does not materialize, I can sell based on failing my first condition.
The DDM has served me well in my search for value-priced companies. Using it, I uncovered Kinder Morgan Energy Partners
The same model and value focus helped me find Bank of America
The discount models are key tools in any value investor's kit. Using them to estimate what a company is worth helps protect an investor from overpaying when buying and leaving value on the table when selling.
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