Dividend payments score
An active dividend is the part of profits distributed periodically to a company's shareholders. Another concept, the passive dividend, relates to partner contributions that have not yet been disbursed. This is mainly an accounting concept, and we do not consider it to affect a company's value from an investor's point of view. Hereafter, "dividend" refers to the active dividend, which this score captures.
How to use the score
Although Gradement does not use dividends in its overall is score, we have included this dividend score since many investors only invest in companies that regularly pay dividends. This score provides information on the company's dividend yield. The dividend yield is compared to proxies of the natural and contractual interest rates estimated by Gradement. A value of 0 indicates that the company does not pay dividends, and a value of 10 indicates a very high relative dividend yield. The following table can guide the use of this score:
| Score value range | Interpretation |
|---|---|
| 0 to 5 | Low dividend yield |
| 5 to 7 | Dividend yield similar to the natural interest |
| 7 to 10 | High dividend yield |
This score can be used in conjunction with the dividend payments steadiness score to see if the current dividend level is temporary or is maintained by the company over time.
Theoretical value of a company
From a theoretical point of view, the only element that should be taken into account when valuing any company is its dividend flow. A company's investment value (and that of any asset) is the discounted value of future dividend flows. (Technical Note: When we speak of value here, we do not mean it in the subjective economic sense, as "value" in that sense is not quantifiable. Here, by value, we refer to a fair appraisement. We use the discounted value of the dividend flow to account for the time value of money: a sum of money is always worth more in the present than the same amount in the future).
Consider the following example, which does not take into account the time value of money. Suppose a company is created at the beginning of an accounting period. The partners contribute 100 monetary units (m.u.) to start it. During this first accounting period, the company requests additional credit, purchases assets, and manufactures and sells its product. At the end of this first and only period, the company is liquidated, returns all loans, and pays a 100 m.u. active dividend to its shareholders with the remaining capital. We can see that the value of this company at the beginning of its activity was precisely 100 m.u. The partners contributed exactly what the company was worth and therefore obtained no profitability. If, on the other hand, the company were liquidated in a hypothetical second accounting period, and it also earned another 100 m.u. in this second period, we would have the following valuation:
- The value of the company at the begining = __100 + 100 = 200 m.u.__
- Shareholders's profitability = __200/100 = 100%__ (they have doubled their initial investment)
We can see, therefore, how an investment's value can be calculated exactly as the sum of all future dividend flows. Any other formula for calculating an investment's value is only an approximation of this theoretical value.
Problems of the model
We know, therefore, how to calculate the exact value of any investment. However, we cannot apply it in practice because two limitations prevent its calculation at the initial moment of the investment:
- We do not know what the company's dividend flow will be from today until its liquidation.
- Because of the time value of money (and of any asset in general), future money is worth less than present money. That difference is the __interest rate__ or time preference. Therefore, even if we knew the exact flow of future dividends, we would need to know the time preference (interest rate) to discount (value at current prices) that dividend stream.
Therefore, it is only possible to know a company's exact value ex-post, i.e., at the time of its liquidation. But if we (1) estimate the dividend stream and (2) estimate the interest rates, we could estimate the firm's value a priori. However, in practice, it is very difficult to estimate both values, especially the future dividend stream.
Some investors use this valuation model by estimating the future dividend flow based on the recent past and on assumptions about the business's evolution. At Gradement, we do not use this valuation model because:
- The amount of dividends paid is a decision based more on company policy than on business economics.
- The assumptions used to estimate future dividends tend to be very subjective.
- Any small variation in the assumptions used often causes huge variations in the company's estimated value.
We mainly use the model based on free cash flows. This model solves problem (1) above, but not problems (2) and (3), which are inherent to all investment models. For points (2) and (3), Gradement uses a more conservative model that assumes the company will continue to function in future periods just as it has in previous ones.
Investors who base their investments solely on the dividend level must consider problem (1) mentioned above: dividend payments are now more of a political than an economic decision. Companies that pay dividends often try to artificially maintain the same level of dividend payments, even when profits fall, as announcing a dividend reduction usually causes a drop in the company's share price. In some cases, they may even resort to paying dividends not from profits but from other assets, which in practice means the decapitalization of the company.