When investing, it’s important to place a value on a business that you’re interested in; without this value as a reed, you’d be floundering in the stock market, trying to decide if a company’s a bargain or not. Companies with stable businesses that are consistently churning out earnings, dividends, and cash flows can be easy to value because of their high predictability. But, how might one value a speculative company (herein defined as a firm with high uncertainty in its future business prospects)? Thing is, there is but one key difference between valuing a stable company and a speculative…
When investing, it’s important to place a value on a business that you’re interested in; without this value as a reed, you’d be floundering in the stock market, trying to decide if a company’s a bargain or not.
Companies with stable businesses that are consistently churning out earnings, dividends, and cash flows can be easy to value because of their high predictability.
But, how might one value a speculative company (herein defined as a firm with high uncertainty in its future business prospects)? Thing is, there is but one key difference between valuing a stable company and a speculative one.
The key is…
There are many valuation models available, but to keep things simple, I’d be using the dividend discount model. The basic form of the dividend discount model is this:
|Share Price = (Expected Dividend Per Share One Year From Now / Discount Rate)|
If we assume that both the stable as well as the speculative company pays a dividend, the discount rate can be lower for the former because the predictability of its dividend is much higher.
For instance, we can reasonably guess that the future dividend of Singapore Telecommunications Limited (SGX: Z74) will be at a similar level to what it paid the year before. That’s because the nature of Singtel’s business – the provision of telecommunications services – makes it easier for investors to predict its future. With less uncertainty in the picture, we can afford to assign a lower discount rate to the company’s dividend for the year ahead.
Meanwhile, a speculative firm like commodities trader Noble Group Ltd (SGX: N21), where there is more uncertainty over its future business prospects (price swings in commodities can seriously affect the company’s fortunes but they are hard to foresee), can leave investors unsure about how its dividend would change from one year to the next. There is thus a need for us to assign a higher discount rate to compensate for the higher uncertainty.
The difference in the volatility between Singtel’s and Noble’s dividends is evident from the table below.
Source: S&P Capital IQ
So, if both Singtel and Noble are expected to be dishing out the same amount of dividends in the future, Singtel will end up with a higher value as a result of its lower discount rate.
This makes sense because as an investor, we can accept a lower yield from Singtel if we have higher conviction that its dividends can continue on in the fuure. Meanwhile, who’s to know how Noble’s dividend will change? To make up for the risk of further declines in the payout, Noble’s value may thus be lower.
If we bring everything together, we can now see that the discount rate is the key difference between valuing a stable company as compared to a more speculative firm.
In many instances, there is a fine line between investing and speculating. But, being a prudent investor does not mean that we should avoid speculative companies all together and only focus on stable, predictable firms.
We can still invest prudently in speculative firms. The key here is to ensure that we are being compensated for taking on the higher risk. And, one way to do so is to use a higher discount rate when valuing a speculative company.
There’s more to it when it comes to investing in speculative companies. If you’d like to discuss further, you can come meet David Kuo and the rest of the Fool Singapore team on August 15!
In meantime, if you’d like more investing analyses, insights, and important updates about Singapore’s stock market, you can sign up for The Motley Fool Singapore’s free weekly investing newsletter, Take Stock Singapore. To follow our latest hot articles, you can like us on Facebook.
The Motley Fool’s purpose is to help the world invest, better.
The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore contributor Stanley Lim doesn’t own shares in any companies mentioned.