YouMaketheCall 145tical to the capitalization of earnings technique. An assume d divi-
den dpayment is divi de dby an assume d discount rate, just as an
assume dearnings level was divi de dby an assume dcap rate. In each
case, the questions are (1) What does the expected stream look like
in terms of amount an dgrowth? an d(2) What is the risk that the
amount an dgrowth will not be realize d?
The conceptual difference between the two techniques is that in
discounting dividends you assume that the value of a share of stock
is the present value of the expected dividend payments on it from
now until doomsday. This makes sense because the value of the stock
consists of the payment stream it yiel ds while it is owne dan dwhen
it is sold.
The only reason there will be a gain on sale is that some other
investor wants to buy the payment stream, an dso on. These inves-
tors may or may not be correct or even rational in that determi-
nation, but it is precisely differences in valuation judgments that
lea dto such exchanges anyway. As a result, the value of a share of
common stock resides solely in its expected stream of cash divi-
dends.
Discounting dividends is just as difficult as capitalizing earnings
because both require selecting a highly sensitive discount rate. For
dividend discounting, many people try to minimize this difficulty by
using the subject’s weighte daverage cost of capital. But that is not
a uniquely correct number, an dcalculating it requires just as much
judgment as they are trying to escape.
Calculating the weighted average cost of a company’s indebted-
ness is relatively easy: It is the average interest rate on all long-term
obligations weighte daccor ding to the various amounts of principal
outstanding on each type of debt. Figuring out the cost of a com-
pany’s equity capital is far harder.
The cost of equity is usually defined by what the market expects
the annualize dreturn on the stock to be, combining price appreci-
ation and dividend payout. But what are we really doing here? In
determining a stock’s value, we are trying to figure out what the
return is going to be. If your key variable in that figuring is what the
market expects, you are begging the question. You are assuming the
answer rather than analyzing the question.
You are better off forming your own value judgment. There is no
formula to tell you the answer, as these examples emphasize. Your
only frien dat that point is the Graham-Buffett margin of safety, not
Mr. Market (you may be fallible; we know Mr. Market is).