Estimating Future Dividends
We have discussed various types of dividend payout models. We have discussed the Gordon growth model, the H model, one stage, two stage, multi-stage and even spreadsheet models.
These models are varied in their approach towards calculating the value of a firm. Yet the common link amongst these models is the fact that they all use probable future dividends as inputs to derive the value of the firm as an output.
So in a way, the estimate of future dividends is the fuel that powers all these models. It may therefore be worthwhile to understand what are the techniques used to arrive at these future projections.
There are multiple ways in which analysts can estimate the probable future dividends. Some of them have been listed down in this article.
Dividend Payout Ratio:
Dividend payout ratio is the ratio between the amount of book profits that a company has generated and the amount of cash it is paying off as dividends.
Many companies maintain their dividend payouts as a percentage of their earnings because earnings somehow are supposed to indicate the value creation that the firm has done in a given period.
Thus, if an analyst knows the firms target dividend payout ratio, they can then calculate the expected profits which they can then further use to extrapolate what the dividends in future periods are likely to be. Lets have a look at some sources that analysts can use to obtain this information.
- Notes: The firms target dividend payout ratio is often mentioned in the footnotes that accompany the financial statements.
In fact it is provided with the sole objective of helping the analysts to calculate the probable value of future dividends and value the firm.
- Filings: In many cases, the firm may not explicitly mention the quantum of dividend that they intend to pay. In such cases, empirical evidence can be used to derive a reasonably accurate value. Empirical data can be obtained from the firms previous filings with the stock exchanges.
- Management Discussions: Lastly, many times analysts directly schedule calls with the management to obtain information which may help them value the firm. In such calls, the issue of dividend payout ratio is often discussed. Firms however, are very cautious before they make any promises pertaining to dividend payouts to the investors. Failure to meet these promises often results in a sharp decline of the value of the stock.
Dividend per Share:
Another chain of thought recommends that the dividend payout ratio is not that helpful if the number of shares amongst which the dividend has to be distributed keeps on changing. The firm may maintain a stable payout ratio but by changing the number of shares outstanding, they can change the amount of dividend that will be received by the investors. Hence, dividend per share is the more accurate metric. Once again analyst calls, empirical data or public announcements from the company can be used to derive this value.
Lastly, many analysts prefer not to extrapolate future dividends from any other metric. To calculate the amount of dividends that can be paid out, they first calculate the amount of free cash flow that the firm may have on hand. Then they consider other factors like stage of growth, condition of the macro-economy, competition etc and arrive at an estimate of the amount of dividends that are expected to be paid out.
Needless to say, that this calculation is complex and requires deep understanding of the companys business environment. Hence this method is used quite rarely.
To sum it up, projecting future dividends can be done in a myriad of ways. Each way presents a different level of tradeoff between the quality of the estimate and the ease with which it can be calculated. However, dividends being more stable than other metrics, analysts often obtain accurate estimates regardless of the method that they use for their calculation.
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