Discounting the future

In such circumstances, it is important to have anchors, points of reference that help us shift away from what’s changeable and beyond our control and towards that which is more stable and we can affect – such as whether to stick with this equity in our portfolio or switch to that one.

In the past few weeks, Bearbull has offered two such means. First, how to tweak tested company valuation models for a year with no profit, no cash and heightened risk thereafter (see 27 March 2020). Second, how to stress-test a company’s ability to pay dividends (see 17 April 2020).

Now let’s turn to the dividend discount model (DDM) in its multi-stage format. It is a good tool to examine the value of companies operating in the ‘90 per cent economy’, where what will be missing most is the marginal revenue that turns loss into profit. That’s because the multi-stage DDM easily copes with companies operating in a world that looks like the 2020s – where many make no profit (and pay no dividends) in the next year or so, then generate fast growth from a low base before the pace flattens.

Underlying the DDM – indeed, underlying all valuation processes – is the notion that the receipt of money in the future is less certain than the receipt of money today. To allow for that, its value must be ‘discounted’ (ie, reduced) by an interest rate; the greater the uncertainty, the higher the interest rate. That’s the same as insisting on more for a sum to be received in, say, a year’s time than one received today. Yet somewhere there is an implied interest rate that makes it acceptable to defer the payment – maybe £100 today would be preferable to £110 in a year, but the likelihood of £112 in a year would swing it.

Applying that logic, usually to the dividends a company pays, is all that happens in a dividend-discount model. The discount factor used for the table is 8.5 per cent, meaning the real value of future dividends is reduced by 8.5 per cent a year. That crucial figure serves as the return an investor seeks; a more bullish investor would be satisfied with a lower return (and would find more value), a pessimistic one would want something higher.

The table shows key data from applying the multi-stage DDM to two holdings in the Bearbull income portfolio – bowling-alley operator Hollywood Bowl (BOWL) and foundry-consumables supplier Vesuvius (VSVS). Click on the link below to access Excel spreadsheets of the model plus explanatory notes and worked examples for the two companies.

The outlook for Hollywood Bowl is worse; total shutdown today and only partial reopening in the summer. Strong finances before the shutdown and an £11m share placing last month mean the group’s existence is not threatened. Even so, I assume no dividends this financial year or next. Thereafter, dividends resume at a tentative 4p in 2021-22 (compared with 12p in 2018-19), grow at 30 per cent a year for three years, then 12 per cent a year for the following five before moderating to the long-term growth rate (4 per cent) thereafter. Put those factors together and the DDM produces value of 181p, comfortably above the market price.

For Vesuvius, the outlook is less bleak. The group has sound finances and has continued to trade, although it has been hit by the closure of some customers’ factories. A dividend for 2020 is surely a non-starter, but I can imagine 12p for 2021 (compared with almost 21p in 2019). That would rise at 16 per cent a year then 10 per cent through two ‘supernormal’ phases before dropping to a 4 per cent long-term rate, producing value almost equal to the company’s 398p share price.

In both cases, note that most of a company’s value is driven from the long-term constant-growth phase, where dividends accrue slowly but remorselessly. This may offer a clue to why share values have been so little affected by current events – a year or two’s profits mean little in the long run. Note also that I could have got any value I wanted – I just have to play with the assumptions. That’s partly the point. The aim is not to find theoretical valuations, but to examine the assumptions lying behind the market’s real valuation. That truth lies behind all models, epidemiological ones included – modelling is vital even if the forecasts models produce are useless.