The Four Stages of Evolution in Equity Share Valuation: 1.Dividend Capitalization Method-The Concept, Trigger and Limitations

Large businesses and business intending to be large are organized as companies for they provide the triple advantage of

  • ‘Existence at will’ for they survive till their shareholders decide to dissolve them
  • Limited liability enabling many unrelated investors to collaborate, and
  • Transferable shares, providing liquidity to their shareholders without impairing the liquidity of the Company

A key ingredient that ensured the growing success of companies is the evolution in valuation of shares that permitted shareholders to sell and investors to buy shares without diluting any of the economic advantages of ownership.

The evolution of share valuation is episodic, marked by stock market bubbles and often a major scandal that highlighted the limitation of the valuation method used which burst the bubble. The first of the four methods is the Dividend Capitalization method that evolved in the 18th century, followed by the Book Value method of the 19th century and the Price Earning Ratio of the 20th century. The 21st century saw the advent of dotcom/internet companies with long gestation periods that gave rise to the technique of valuing even loss-making entities with potential.

This article captures the concept, the trigger and the limitations of dividend capitalization method. In the next three articles, the concept, trigger and limitations of the other three valuation methods that followed the dividend capitalization method will be described.

The Concept

Lending and borrowing are concept that can be traced back to almost the beginning of human civilization. As these practices evolved, around the end of 17th century the concept of annuity bonds came into being in Europe, where the government would borrow money from its citizens and pay a fixed interest amount once every year to them. These bonds were called annuities as interest was paid once a year.  The rate of interest paid on these bonds varied with the amount of money required by the government and the demand for these bonds from the citizens. Over time bonds with multiple interest rates came into being, example bond-A paying 6% interest and bond-B paying 8% interest. Once trading in bonds started, the price of the bonds could be related to the return they paid. If bond-A was trading at 100, Bond-B was priced at 133.33 (100 divided by 6 multiplied by 8) or if bond-B was traded at 100, bond-A was priced at 75 (100 divided by 8 multiplied by 6).

When trading in companies’ shares started, their pricing was related to the bonds as they were seen as bond variants and hence initial pricing was related to dividend paid. If a company paid 8% divided, the company share price was equal to a bond paying 8% interest. With the result higher the dividend a company paid, higher would be its share price.  The limitations of this method of valuation was highlighted when the first stock market bubble in the world burst in the year 1720.

The First of First

The year 1720 marks the first stock market boom. The place was London and the company at the centre of this boom was Southseas Company. Between January and June of 1720, the share price of this company went up from £128 to £1000 pounds. Among the techniques used to keep the share price high, announcing high dividends was a key factor. In August, the company announced 30% dividend for December, and it also promised a dividend 50% for the next decade.  On August 24th as a show of confidence, it announced a fresh issue of £1 million at a price of £1000 per share. Despite these measures the share price did not react positively and it crashed by December 1720 to its January level.

Lessons Learnt

Even though shares are like bonds paying a periodic yield to their holders, there is a basic difference. While interest payments on bonds are contractual payments, dividend payments on shares are discretionary payments subject to the profits in the company and the decision of the Board of Directors.  Hence Dividend Capitalization as a method of valuation is of limited use today, superseded by more advanced methods that evolved in the subsequent centuries. However, for anyone studying equity valuation, Dividend Capitalization is the place to start, but with a long road to travel that lies ahead.

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