The firm-foundation investing theory

Each investment instrument has an intrinsic value which can be determined by careful analysis of present conditions and future prospects. Investing is then just a matter of buy or sell decisions comparing actual price with its firm foundation value.

From the point of view of the very-long term investor, the worth a share is the present or discounted value of all future dividends he will receive from owning the stock.

Four fundamental determinants affecting value of shares

Determinant 1: expected growth rate

A rational investor should be willing to pay a higher price for a share:

  • the larger the growth rate of dividends, and
  • the longer the extraordinary growth rate is expected to last.

Determinant 2: expected dividend payout

A rational investor should be willing to pay a higher price for a share, other things being equal, the larger the proportion of a company’s earnings that is paid out in cash dividends.

Determinant 3: degree of risk

A rational investor should be willing to pay a higher price for a share, other things being equal, the less risky the company’s stock.

Determinant 4: the level of market interest rates

A rational investors should be willing to pay a higher price for a share, other things being equal, the less risky the company’s stock.

Three caveats

  1. Expectations about future cannot be proven in the present, therefore, prediction of future earnings and dividends implies always a dose of uncertainty.
  2. Precise figures cannot be calculated from undetermined data (the information used to make the calculations is based on estimates).
  3. The fundamental determinants are liable to change depending on market psychology (stocks are bought on expectations, not facts).

Further reading