The world of investing is filled with acronyms. As a keen student of investing for more than a decade, I’ve committed my fair share of such acronyms to my memory. But recently, thanks to my colleague Chong Ser Jing, I came across an interesting acronym which I have never seen. In an investing book he had co-authored titled “Invest Lah! The Average Joe’s Guide To Investing,” I learnt about the acronym called GIGO – garbage in, garbage out. It’s one acronym which investors should know because the term had been used by Ser Jing in the book to discuss the dangers…
The world of investing is filled with acronyms. As a keen student of investing for more than a decade, I’ve committed my fair share of such acronyms to my memory.
But recently, thanks to my colleague Chong Ser Jing, I came across an interesting acronym which I have never seen. In an investing book he had co-authored titled “Invest Lah! The Average Joe’s Guide To Investing,” I learnt about the acronym called GIGO – garbage in, garbage out.
It’s one acronym which investors should know because the term had been used by Ser Jing in the book to discuss the dangers inherent in something that most business-focused investors would have done before – the act of valuing a company.
Be careful where you dump your waste
When it comes to valuing a company, the most crucial part of the process is coming up with our assumptions for the inputs. And this is where we have to be aware of GIGO – if our inputs are garbage, our output will most certainly be rubbish.
Valuing a firm
Let’s use Starhub Ltd. (SGX: CC3) as an example. As a telecommunications service provider, Starhub had been enjoying stable revenue and earnings growth over the past five years between 2009 and 2013, as seen from the chart below.
Source: S&P Capital IQ
In addition, the firm has also been paying steady dividends, which has been plotted in the same chart. During that period, Starhub’s top- and bottom-line had increased at an annual compounded rate of 2.3% and 3.6% respectively.
Since Starhub has been such a consistent dividend stock, we could perhaps make a simple assumption that the company will continue paying out a dividend for many years into the future and also grow those pay-outs at a rate similar to its top-line growth.
These assumptions means that a suitable valuation tool for Starhub could be the dividend discount model (DDM).
The dividend discount model
Under a DDM, the value of a share is given as:
Value = Next Year’s Dividend per Share / (Discount Rate – Dividend Growth Rate)
The key assumptions going into my inputs for the DDM are as follows:
- The dividend next year will be 2% higher than what has been paid in the firm’s last fiscal year. In 2013, Starhub’s dividend was S$0.20 per share, so a 2% increase would become S$0.204 per share.
- The discount rate used will be 6%. It might seem low, but it could be justified given that it’s already double the current risk-free rate in Singapore (taken to be the yield for Singapore’s 10 year sovereign bond) and Starhub is a stable company.
- The growth rate for the dividends is 2%, similar to the firm’s historical revenue growth rate.
With the above assumptions, my calculation of Starhub’s value would be:
Value = 0.204 / (0.06-0.02) = S$ 5.10 per share.
Given Starhub’s current price of S$4.16, my calculated value of Starhub’s shares would make it seem like a bargain now, right? Not so fast.
If you’re going to use a different set of assumptions with Starhub, you’re going to get a wildly different answer.
A negative light
Let’s say you have a dimmer view of the future of Singapore’s telecommunications companies as you think that the whole industry is going through a structural decline.
You think that cable television might no longer be popular, given the advent of online television and websites like Youtube – this would be bad for Starhub’s Cable TV segment.
You might also think that landlines are a dying business, with long-distance calls migrating to platforms such as Skype – this can’t be good for Starhub.
Then, you’re also of the view that SMS-es will no longer be needed and that phone calls would be made through apps or programs like Viber and Skype – this would kill off Starhub’s mobile business.
So, what we’re left with is a Starhub that merely provides internet and data through broadband connections or 3G services and the likes.
With such a view of Starhub, your assumptions for a DDM might look like something like this:
- The dividend per share will drop by 3% next year, giving rise to a S$0.194 dividend.
- The discount rate will be bumped up to 15% to reflect growing risks in Starhub.
- The growth rate for Starhub’s dividends is set to a negative 3% to be coherent with the view that large parts of the firm’s business is being replaced by other competing services.
When we pull all these together, the value of Starhub will thus be:
Value = 0.194 / (0.15 – (-0.03)) = S$1.08 per share
I hope you are able to see the huge difference you can get in a company’s value depending on the assumptions made. So, the next time you try to value a company, think about your assumptions and how it might impact the result. And, don’t forget GIGO.
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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore writer Stanley Lim doesn't own shares in any company mentioned.