In this contribution we use the Dividend Discount Model to derive a set of interesting conclusions. It looks as if stocks are about to enter a good period, but beware: Emerging Markets stocks will remain more sensitive to changes in market climate.
Introduction: The Dividend Discount Model
The Dividend Discount Model (NYSEARCA:DDM) dates back to scientific work in the 1950s, with Prof. Myron Gordon playing a central role in its development. Basically, the DDM states that the price of a stock equals the net present value of its future dividends. Of course, the bulk of investors will not hold stocks until the end of time and decide to sell shares somewhere in the finite future. But at that moment, its fair value price will be equal to the net present value of future dividends plus expected sales price for the next investor in line. Result: in the end we can substitute the sales price component by future dividend series, so that in the end the following equation holds:
Price = D1/(1+k) + D2/(1+k)^2 + ..... D(inf)/(1+k)^inf
With stable dividends D1=D2=D3.....=D(inf) this translates into Price = D/k and with a stable growth rate g in which Dn = (1+g)*(D(n-1)) this translates into Price = D(k-g).
Under the influence of growing interest in the Capital Asset Pricing Model that looked more at returns than prices and because it was clear that fair values and actual market prices could deviate substantially - and as will become clear later in this article, this tendency might even be growing! -, the interest in DDM has deteriorated somewhat. But we felt that it is an interesting tool to analyze some important sensitivities of stocks, especially when comparing 'the average' developed market stock with 'the average' emerging market stock.
DDM comparison of two stocks, one from a Developed and one from an Emerging Market environment
In this entry we compare two stocks. Let's assume that they are energy stocks. Both post an earnings per share (NYSEARCA:EPS) of USD 1. The first firm is a developed market firm (let's say its name is DMF). For longer periods during its history this was a stock characterized by a below-average risk because of the defensive qualities of the energy sector. But recently its market risk has moved toward 'average' with the market risk indicator BETA now equal to 1.0. Reasons for this gradual shift towards 'average' are first of all competition from energy stocks in Emerging Markets who now - due to globalization and the growing demand for energy products in the world - turn out to be fierce competitors. DMF is a mature firm that pays out 50 percent of its earnings in dividend. GDP growth rates of the mature economy that DMF belongs to normally range between 1 and 4 percent. DMF is a good firm, definitely a market leader in its own right, and we do therefore believe that - taking into account growing energy demand as well - that DMF can post a 5 percent growth rate per annum.
Its natural Emerging Market competitor is EMF. This firm post an EPS of USD 1 as well. But the market risk is still higher with a BETA of 1.5. Traditionally the correlation of Emerging Market stocks with the Global Market has been lower, but recently - due to globalization - the correlation coefficient is creeping up. Knowing that the market risk factor BETA is by definition equal to r x (vola(NYSE:EMF)/vola(NASDAQ:WRLD)) with vola(EMF) representing the volatility of EMF and vola(WRLD) the volatility of the global stock market index, we assume that this increase in correlation implies that the tendency of gradual volatility decrease at EMF due to ongoing development of financial markets within the Emerging countries is to such an extent compensated that BETA is still above average. We believe that this is a pattern that will be reality for most Emerging Markets countries for quite a few years to come.
To finalize the calculation of the relevant discount rate for our DDM for EMF and DMF we need to make base assumptions for the Risk-free Rate (Rf) and the Required Market Rate of Return (Rm). For the Risk-free Rate we use a rate of 5 percent per annum. For the required rate of return on the market we use 12 percent. That might seem to be a bit high, leaving us with a historically high Equity Risk Premium. But then again: don't forget that we are dealing with a period immediately after a Global Crisis and one in which the world is changing. For the first time ever the dominance of Developed Nations is challenged by Emerging Nations. That will translate into uncertainty and it is not unlikely that this will translate into nervousness and relatively high required rates of return on equity. Table 1 below gives the base data and calculates fair values.
Table 1; Base Data - Dividend Discount application
Using the base data we can derive that the fair values for DMF and EMF are USD 7.14 and USD 4.55 respectively. DMF is less risky and it pays out a higher dividend. This translates into a higher valuation. When comparing the Price Earnings Ratios with those in the market today, we can conclude that our required rate of return of 12 percent for the market is maybe a big too high. If we replace the 12 percent rate by a rate of 10 percent, we reach the remarkable conclusion that the two stocks DMF and EMF have the same value! With a required market rate of return of 10 percent, both have a fair value share price of USD 10. In other words: EMF benefits much more from a lower required Equity Risk Premium than DMF. As a result, its higher expected growth rate and lower payout ratio compensate for its higher risk and lower initial dividends when comparing it with DMF.
Using a required market rate of return of 10 percent did translate into a P/E of 10 for the two energy stocks. More in line with valuation for developed and emerging market energy stocks today. And if we reduce the required rate of return Rm further to 9 percent per annum, the stock price for EMF increases further to 25 - with an accompanying PE of 25 - and that of DMF increases to 12.5 with an accompanying PE of 12.5 Looking at our little DDM we could therefore conclude that markets are currently using a required rate of return somewhere in the 9-10 percent region.
But what is interesting to see, is the sensitivity of valuations to little changes in the relevant parameters. The model indicates clearly how both bottom-up, fundamental indicators and top-down valuation factors play a role when deriving share prices with the DDM. The payout ratio, the earnings growth rate and the stock beta are 3 examples of bottom-up fundamentals. The risk-free rate Rf and the required market rate of return Rm are two examples of top-down macro indicators.
In the remainder of this note we will analyze the impact of these five indicators on our two representative stocks DMF and EMF. What are the most important factors when it comes to sensitivity of valuation to changes in the underlying indicators? Is there a difference between the sensitivities of the Emerging and Developed Markets stocks? In the following paragraphs we will first look at the impact of individual factors. In the concluding paragraph we will then compare them with each other.
Sensitivity to Earnings Growth
In table 2 we show in the first part of the table how share prices change when we change the earnings growth rate with 1 percent steps over an interval ranging from 1 percent to 11 percent. The gray cells indicate our base positions for DMF and EMF. In the second part of the table we analyze the price change in case of a 1 percentage point disappointing or surprising growth outcome (i.e. a surprise of 1 granularity compared to the gray equilibrium value). All other factors related to the base scenario are left unchanged.
Table 2 Sensitivity to changes in earnings growth
The Emerging Market stock EMF - with its higher expected earnings growth rate - is slightly more sensitive to earnings growth surprises or disappointments than the developed market stock DMF. To some extent this is not really a surprise, because EMF - with its lower pay out ratio - will use a relatively larger part of this retained earnings for (higher) earnings growth in the future.
However, when looking at the minimal versus maximal growth rates (1 versus 11 percent) and the accompanying stock price, we see that the range for DMF goes from USD 4.55 (coincidentally the base price for EMF!) to USD 50 for the developed market stock versus a range from USD 1.72 to USD 5.56 for EMF. In other words: when looking at the total bandwidth DMF is more sensitive to growth. This is related to the lower risk profile of DMF.
Sensitivity to market risk BETA
In table 3 we analyze the sensitivity of both stocks to changes in market risk, BETA.
Table 3; Sensitivity to Market Risk: BETA
The Emerging Markets stock EMF can not reach BETA levels of 0.6 or 0.7 with the data set used here. Those kind of low risk levels are impossible with the growth data used. Higher growth translates into higher potential disappointments and that leads to a lower limit for BETA. The sensitivity of EMF to BETA changes is larger. And with current risk levels of EMF being relatively high - with risk reductions as a result of financial market developments in Emerging Markets being more likely than increases - one might expect that improved developments within the financial systems in Emerging Markets will translate into upward adjustments in share prices. However: the likelihood of this to happen is not as big as what lots of scholars expected some 10 years ago. Reason: globalization has led to increased correlation of Emerging Markets stocks with the World Index as well, and only to the extent that volatility reductions more than compensate for increased correlations, will BETA reduction really materialize. But we believe that stocks in relatively stable, defensive industries within Emerging Markets will still have sufficient BETA reduction potential.
The other way round: stocks in developed markets are also faced with growing complexities of a Globalizing world. They will either have to opt for a specialization into the direction of 'high yield' / lower risk stocks (larger payouts, less growth, lower risk) or - through increased investments in Emerging Markets - try to re-ignite growth. The latter will lead to increasing risk levels, but the successful firms will be capable of compensating this with ofsetting additional growth through their affiliates in Emerging Markets.
Sensitivity to Payout Ratios: Growth Stocks versus Yield Stocks
The last lines of the previous paragraph hinted on something important. In a Globalizing world cross-border specialization of firms will also include opting for one of two feasible business models. Firms that believe that they are strong in finding new growth opportunities (either at home or in Emerging Markets with their above-average growth rates) could keep their payout ratios relatively low and use the retained earnings for above-average investments in future growth.
The other way round - and that is especially so in an environment that due to demographic factors will probably be characterized by historically low average interest rates - firms could also opt for relatively high payout ratios. This will lead to interesting dividend yields that will make this type of stock a nice alternative for fixed income securities. These stocks will not show spectacular earnings growth, but the relatively low risk and attractive dividend yields will make them an attractive market niche for investors looking for stable returns. Especially firms from developed markets in industries that have matured might opt for this business model. A good example of firms that have gone this way are the tobacco and cigarette producers. After periods of above-average growth health factors have suppressed their growth in developed nations with substitute demand from Emerging Markets consumers not strong enough to compensate for lost demand from developed nations. For many years stocks like British American Tobacco and others have provided their investors with interesting alternatives to regular fixed income securities. But with expected interest rates in the future probably - on average - lower than what we have seen in the past 50 years due to demographic factors, the market interest in high yielding stocks will increase further.
When looking at the overall bandwidth for payout ratios between 70 percent and 20 percent there isn't much of a difference in sensitivity when comparing DMF and EMF. The range of fair value prices for DMF goes from USD 2.86 to USD 10 and for EMF it goes from USD 3.64 to USD 12.73.
However, the average emerging market firm is currently keeping its payout ratios lower than the average developed market stock. Logical, financial markets in emerging countries are far less developed. It is not so easy to issue new stocks just as easily and/or attract loans. And it is not just because of money supply factors in financial markets that firms in Emerging countries keep their payout ratios lower. They do of course - in their faster growing markets - also have more interesting investment opportunities.
So, when looking at payout rate sensitivity we see that this is a factor twice as important in Emerging Markets as it is in Developed Markets. Actually, as we will see later when comparing the various sensitivities, Payout Ratio is the second most important factor of the five we are analyzing. And the most important bottom-up variable. It helps explain why Emerging Markets firms that opt for higher dividend do normally do so well in the market. Dividends are a scarce resource in these markets. A scarce resource that translates into lower relative risk and stocks of a 'value' type. These Emerging markets 'value' stocks form an attractive outperforming category within Emerging Markets portfolios. On the other hand: make sure that you invest in higher yielding stocks in Emerging Markets that know what they are doing. If the CFO is not planning the firm's dividend policy carefully, reductions in payout ratios later will lead to substantial price drops.
Sensitivity to changes in the Risk-free Rate
The first of the two macro variables that we will look at, interest rates, turns out to be the least important of the 5 factors under study. Amazingly, changes in the interest rate are not important at all when studying the valuation of DMF. When the risk-free rate Rf increases by 1 percent, this will be compensated for by a reduction in the equity risk premium of exactly the same amount as a result of which our stock DMF is not affected since it had a BETA of 1.0.
The Emerging Markets stock EMF is however affected, because its BETA was unequal to 1.0. With its above-average BETA the negative impact of an increase in interest rates of the equity risk premium was more important than the increase in the risk-free rate itself. Result: increased interest rates make the valuation gap between DMF and EMF smaller.
Table 5; Sensitivity to Interest Rate Changes
But Table 5 shows it clearly: unless we incorporate the impact of interest rates on other factors (i.e. more than one change at the same time), interest rate changes are not the most important factor.
Sensitivity to changes in the required rate of return Rm
The last factor that we analyze is the one that we already started with: changes in the required rate of return in the market Rm. Table 6 shows that this is the most important factor of all for both DMF and EMF. What rate of return do investors demand on their equity investments? As we know from the Global Crisis and its aftermath on the one hand (nervous market climate, high required rate of return) and the build-up to the Crisis (exuberance, relatively low required return) on the other, we know that changes in market sentiment can quickly translate low valuations into high ones and vice versa. The speed with which these changes might happen is a function of investor nervousness. And in this world of Global Change, with Emerging nations now for the first time demanding a large share of the world in a world that went from two dominating power blocs (USA and Europe) to one in which now Emerging Nations are also approximately of equal importance (with a GDP weight of about 35 percent) it is more than likely that nervousness will remain relatively high.
And this will translate into a valuation situation in which it is most important to get the global market climate right. When the sentiment is relatively good, overweigh Emerging Markets but make sure that you reduce your EM overweight when the sentiment changes and uncertainty returns. It is not surprising that in this market environment precious metals like Gold did so well recently.
Table 6; Sensitivity to Required Market Return Changes
Evaluation: Comparing the sensitivities
In table 7 we compare the various sensitivities. We do so by first looking at the bandwidth between a 1 granularity surprise and 1 granularity disappointment in the tables 2 to 6. Then we rank the 5 different sensitivities for both developed and emerging markets. The Required Rate of Return Rm is the most important factor and Interest Rate Sensitivity is the least important factor for both EMF and DMF, with the caveat being that interest rate sensitivity can become more important if accompanied by other changes. But in this analysis we focused on individual changes in each of the 5 variables while keeping the other 4 stable.
Table 7; Sensitivities Compared
In the last 2 columns of table 7 we look at the differential sensitivities. Emerging Markets stocks like EMF are always more sensitive than comparable stocks from developed markets. That is a fact of life that all investors in these stocks should never forget when comparing them with developed market stocks. However, there are two factors - one macro and one micro - where the differential impact is far bigger than for the other three. The first one is the required rate of market return, indicating that Emerging Markets stocks will remain more sensitive to positive surprises in periods of positive momentum and negative surprises in cases of panics. The second one is related to dividend policy. When stocks in Emerging Markets will increase their payout the signaling effect is far bigger than what Western investors might be used to in their own markets. And the other way round: the negative signal related to a reduced payout will cut deep in Emerging Markets.
It is nice to get this overview of sensitivities using the Dividend Discount Model. We conclude with the following set of general conclusions that you should keep in mind when investing in a portfolio of Emerging and Developed Markets stocks:
- Notwithstanding their above-average growth rates and good developments, stocks from Emerging Markets countries will continue to be far more sensitive to changes in relevant macro and micro variables than stocks from Developed Markets.
- In a Changing World characterized by Globalization and a change from a Two- to Three-bloc equilibrium in which Emerging Markets as a group will demand a fair share of the action, nervousness, confusion, exuberance and panic will not disappear but if anything play a bigger role.
- This will translate into higher average volatility and relatively longer and more periods during which fair value prices can deviate substantially from market prices.
- This will provide opportunities for smart-money investors while at the same time making markets more complicated for non-specialists.
- Investors who want to make use of the deviations from fair value do best to build diversified portfolios using a disciplined valuation methodology in which mean-reversion plays an important role.
- Although the Dividend Discount Model is nothing more or less but a theoretical valuation framework, it can help us get a good overview of market sensitivities and that is of extreme importance in a Globalizing world in which international dependencies of stocks and factors will grow.
- When applying the simple model presented here, it looks as if today's investors demand a 9-10 percent required rate of return Rm.
- When comparing this with today's risk-free interest rate levels, this translates into a historically high equity risk premium.
- The equity risk premium might drop due to increases in interest rates, but it is far more likely that investors will reduce the required rate of return as a result of which we might enter a relatively good period for stocks.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.