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Ben Inker - How to value stocks

  • MAY 11, 2009, 9:48 A.M. ET
How to Value Stocks? Ignore Economic NewsInvestors trade on the belief that share values are closely related to the economy. They shouldn't.
The stock market jumped 6% last week on growing hopes of an imminent economic recovery. It has risen 39% from the March lows on similar hopes. Of course, it had previously fallen nearly 60% on fears of a slump.

All these moves have one thing in common: Millions of investors have acted on the belief that share values are closely related to what will happen in the economy in the next few months and years. But are they right?

Not according to Ben Inker, director of asset allocation at contrarian fund company Grantham Mayo Van Otterloo & Co. In a recent and fascinating note ("Valuing Equities in an Economic Crisis, or How I Learned to Stop Worrying about the Economy and Love the Stock Market"), Mr. Inker persuasively argues that the next moves in the economy shouldn't actually matter too much to investors at all.

Why? Two reasons.

First, because most of the value of shares really depends on the cash they will generate many years, even decades, ahead. The next few years are only a minuscule part of the equation. "Since stocks do not have an expiration date and dividends grow over time," Mr. Inker argues, "the duration of stocks is extremely long. If we assume that half of the return from stocks in a given year comes from the dividends and half from the growth in dividends, most of the value of stocks comes from cash flows in the distant future."

How distant? Using Mr. Inker's hypothesis, it turns out that about 75% of the value of shares is actually based on dividends that will be paid more than eleven years from now. Half the value is based on dividends to be paid after 25 years, and a quarter on those to be paid after about 50 years.

In other words, when you look at the market today, three quarters of its true value is based on what companies will earn and pay out after 2020 and half is based on what they will do after 2034. So really, how much attention should you pay to next quarter's earnings?

This is counterintuitive to most investors. Mr. Inker does not go into his math in detail, but some simple calculations may illustrate the point. Imagine, in a perfect world of smooth returns, you buy a $100 basket of shares today with a 7% earnings yield. They pay out half these annual earnings in dividends, and reinvest the rest to grow. In the first year you have a $100 investment earning $7 and paying $3.50 in dividends. In year two that's grown to a $103.50 investment earning $7.25 and paying about $3.62 in dividends. And so it goes over time. After 10 years your investment has grown to $141 and the dividends are $4.94. By year 25 the investment is worth $236, and the dividends are $8.27. If you look out 100 years, your investment is worth a remarkable $3,119 and the dividends are $109, or more than the original purchase price.

You probably won't hold on till then. (Your grandchildren might not, either.) But the value of that soaring income stream is built into the price we pay when we buy shares today for $100, and sell them 25 years from now for $236. Even after discounting future earnings -- a dollar next year is worth slightly less than this year, and so on -- these distant earnings form an incredibly large part of today's value, simply because they are so large.

There is a second reason for not paying too much attention to the economy's next move. No matter what happens next month or next year, sooner or later the economy will probably find its way back onto its long-term path anyway. If we now boom wildly, we'll pay for it with weaker growth down the line. And if things are bad for a while, eventually they'll pick up. That can be true even for devastating blows. GMO's calculations show that by the late 1940s, Mr. Inker writes, the U.S. economy had returned to the long-term growth path "as if the Depression had never happened." And that was even true by the late 1950s for West Germany after the devastation of the Second World War.

This sort of analysis is a useful antidote to stock market moods.

Wall Street is back on its happy pills again. At some point, maybe even soon, brokers may start urging us to pay too much for stocks on the basis of this year's economic growth or next. Canny investors may respond: But what about 2034?