One of the topics not discussed on this blog is
evaluating a stock in
terms of the net present value of its future dividend income stream. This technique was first
proposed by Irving Fisher and rumour has it, that Warren Buffett also used to
calculate investment value in terms of net present value of its future
income stream. Irvin’s method is official called: DDM or Discounted Dividend
Model. You may have come across the world famous future value/net present value
equation which goes as follows:

FV=PV(1+i)^{^n}

Where:

FV = Future Value of an
investment

PV = present Value of an investment

i = the discount rate (or rate
of desired return on investment) per year

n = is the investment life expressed in years.

Thus a dividend of
$3 to be received 5 years from now (FV = $3) and assuming an interest rate or
required ROI (i or further down it is: DR) of 10% would be worth today $1.86 using the equation below:

PV=FV/(1+i)^{^n}

You could not only
calculate the net present value of each dividend you will receive over the next
five years, you could do so for an infinite number of years (assuming your
investment never terminates, i.e. the ultimate Buy&Hold). When you add up all those to net present value converted dividends then the sum would represent the share's (net present) value. This would entail
a lot of calculator math, but fortunately, mathematicians found that the answer
can be expressed as a very simple equation:

MV=PD/(DR-DGR)

Where:
MV = Market Value (of a share)

PD = present or today's dividend per share

DR = aforementioned discount rate

DGR = Dividend
Growth Rate

For the Dow Jones
Industrial Index, the dividend growth rate historically averages 5% (more or less the same as nominal GDP growth of the U.S. economy). The
current dividend yield is 2.5% or $319.73 and today’s index price is: $12,789 (the Dow is 12,789 right now - just put a dollar sign in front of it).

Thus if an annual
return on investment (DR) is required of 10%, then according to the DDM the DOW
should be at $6,394 rather than $12,789.
Thus, the expectation of a return on investment of 10% per year is likely unrealistic.
Based on its current value, a ROI (DR) of 7.5% should be a more reasonable
expectation.

You may manipulate
this DDM equation to express the expected market return (DR) as follows:

DR=DY+DGRWhere

DY = Dividend Yield (PD/MV)

I know, the math is excruciating in its complexity J). Today’s DY = 2.5%
and the DGR=5% so the expected annual rate of return or DR is 7.5%.

Of course, the Dow
Jones fluctuates due to a hyper emotional investment community and as such
is on a day to day basis completely unpredictable . Howeverrrr, over the long term, if
you invested today in the Dow Jones Spyder ETF (DIA-N) according to the above
equation, officially known as the Gordon Equation, your annual return should
average 7.5% with all emotions cut out of the estimate.
Thus if you saved $10,000
per annum for 25 years and invested it in DIA-N with a return of 7.5%, your
investment would be worth $679,778. A
tidy sum assuming there is no inflation and no taxes. So let’s assume 3%
inflation and a marginal Alberta tax rate of 38.8% or a 19.9% rate on capital
gains (lets forget about the taxes on the dividends right now). So taxes are $85,525 the remainder being
$594,253. Discounting $594,253 at 3% inflation, the net present value of your
original investment (25 years x $10,000 = $250,000) is: $283,818. You basically broke even in terms purchasing power.

This is one of the
significant observations made by Bernstein, that investing in the stock market
only protects the purchasing power of your original savings. Basically it is a
postponement of today’s spending to spending 25 years from now. Do I agree with
it? Not necessarily. I have run passively managed portfolios for my children. I
invested the money in their education trusts in a number of reputable diversified mutual
funds and the results were indeed very mixed. The funds did their job but not
brilliantly.
On the other hand, we
have reviewed long term stock market performance on this blog or reviewed the
work of Jeremy Siegel (which Bill Gross now claims to represent a ‘historical
fluke’) or the work of Jim O’Shaughnessy that goes back to the early 1900s.
These works indicate returns of 13 to 18% or 7% plus inflation. Another non-emotional way of estimating the
return to expect from a stock is to use its

*earnings*yield instead of its d*ividend*yield.
After all, you the
shareholder owns the entire profit not just the dividends. As such, not only
do dividends grow but the retained earnings are added to the assets of the
company. This should result in capital gains in addition to the dividends. So if
we use Gordon’s modified equation and assume that earnings growth is as fast as the
dividend growth while the Dow currently trades at a P/E of 13 or an earnings
yield (EY) of 1/13= 7.6% then return over the long term should be:

DR=EY+DGRWhere

EY = Earnings Yield (1/PE)

The result is DR =
7.6+5 = 12.6%. In this scenario of $10,000 annual savings over 25 years would be worth $1.46
million minus $241K in taxes with a NPV discounted for inflation (3%) of $583,316. Since one needs a net worth of around $1.5 million
to retire (A
Portfolio of Viable Investments) with some comfort I do not think that
investing in the Dow Jones will make you very rich. Over the next while, we
will discuss how we could try to become rich(er).

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