ABSTRACT
§ 0-1. In 1937, John Burr Williams argued that an asset’s value should be calculated by determining the present value of the future cash flows one expects to receive from it. ‘A cow’, wrote Williams, ‘for her milk. A hen for her eggs, and a stock, by heck, for her dividends. An orchard for fruit, bees for their honey, and stocks, besides, for their dividends.’ Thus, said Williams, since future dividends are the cash flows one expects to receive from an equity security, it necessarily follows that one should determine the intrinsic, long-term worth of the given equity security by calculating the present value of the dividends that one expects to receive from it. Nowadays, this approach for determining the intrinsic or fundamental value of an equity security is widely used in the financial markets, although less rigorous methods such as price–earnings multiples are still in evidence. In applying the dividend valuation approach, security analysts and investors determine the intrinsic value of an equity security by first estimating the future stream of dividends they expect the equity security to pay. They will then apply an appropriate discount rate to the estimated stream of dividends in order to determine the fundamental or intrinsic value of the given equity security. If the intrinsic value of the equity security exceeds its market price, they will regard the equity security as a ‘good’ investment. In contrast, should its market price exceed its intrinsic value, they will label the equity security as a ‘bad’ investment. It thus follows that the discount rate applied to the dividends a company is expected to pay will be an instrumental determinant of the intrinsic or fundamental value that analysts and investors will calculate for the equity security. Given this, the first chapter of this book is devoted to issues surrounding the calculation of an appropriate discount rate with which to determine the present value of a given cash flow stream. In particular, we identify some of the pitfalls that can arise from the incorrect calculation and averaging of the returns that accrue on equity securities and other financial instruments. This chapter also illustrates and provides a brief introduction to the numerical procedures that can be used to determine the return on fixed-interest securities, such as mortgages and bonds.
