Dear Owner:
We now have a basic understanding of income and risk and the relationship of income to risk is the foundation of any valuation model. A basic valuation model was demonstrated already being income divided by the required rate of return an investor would need to invest. This blog introduces the application of growth into the valuation model.
Growth is a new concept and it relates to the future increase of income. We know that growing income increases value of the company, but the growth rate also decreases the risk of the company. Growth is introduced in the Dividend Discount Model:
Dividends
(Risk – Growth)
This model takes the EAT we learned in the last blog entry and divides it by risk LESS growth. We have discussed the value multiplier “5x income” to be the same as “income divided by 20%” and that comes from this model. If we assume all after tax income is distributed to shareholders, then dividends equates to income and this model is a good reflection of corporate value.
There is one consideration when making decisions to grow corporate value; growing income has to come without increasing business risk. Making a decision for one at the expense of the other could decrease corporate value or at the very least grow it slower.
The DDM assumes perpetual growth at whatever rate put in the model. For the long term, this is typically inflation. Therefore, if a company is growing but the growth rate is decreasing, it will lose value. This is why new products/services or new markets are important just to sustain value.
As an illustration, when you introduce a new product into the market, you typically increase your income by increasing your revenue AND margins on that new product. So income is higher and growing. The DDM thus sees income and growth higher having a double benefit to value. Long term however, competition will come into the market and bring down the margins and growth to normal market levels. Corporate value will decrease by virtue of slower growth prospects even if operations are doing well and company is making money.
Tags: Business risk, corporate value, Dividend Discount Model, dividends equates, growth, income, inflation, multiplier, perpetual growth, required rate of return, Risk, shareholders, sustain value, tax income, the long term, valuation business model
