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