Understand how to make a good investment in an asset that pays dividends – 03/18/2023 – From Grain to Grain

One of the elements most misunderstood by ordinary investors is the dividend paid on financial assets. Usually, investors disassociate the amount paid at the time of purchase with the dividend. Wrongly, it is believed that it is an extra money that is earned in the investment. I explain below the value of a dividend-paying asset and what you need to pay attention to in order to make a good investment.

This text will be more technical. For those who want to start understanding this will be a first step. For those who don’t want to go deeper, accept these three lessons:
I – When you buy a dividend-paying asset, you pay for all expected dividends in the future;
II – The amount paid has a discount given by the interest rate and the risk premium;
III – The only way for you to make a good deal is if four scenarios occur: interest rates fall in the future, the traded risk premium is high, the dividends that occur are higher than expected or you pay less than the value fair.

I know that some lessons seem to run counter to what you intuitively understood to be true.

But, the cold hard truth is that when you receive a dividend and it was exactly what you expected, you are just getting your money back corrected for the interest rate. This can be found in any textbook on company valuation, such as the renowned authors of Damodaran or Koller.

The figure below depicts this process. You can access the complete spreadsheet of this table at this link. The worksheet depicts the pricing process of a dividend-paying asset. This is the discounted dividend model for estimating the fair value of a dividend-paying asset.

Line I, in green, shows the fair price of the asset in each year. If you open the spreadsheet you will see that it is simply the present value of dividends to be received over the next 100 years. Any amount received after 100 years, after discounting at an interest rate of 16% per annum, has residual value. Therefore, it does not affect the result.

When a dividend is paid, the share price is reduced from this payment. For example, consider that a share that closes the day with a price of R$ 116. At the end of this trading session, a dividend of R$ 9.0 is declared. The next moment, you have this share priced at BRL 107.0 and a provision for receipt of BRL 9.0. The sum of the dividend and the price equals the same amount of money you had right before the payout. This process is described in the fourth column (year 1) in the figure above.

Thus, as you pay for these dividends to be received, when you buy this stock, real estate fund, real estate or any other asset that pays cash flows, you must pay attention to one factor only: pay a fair value or less.

There are only four ways you can pay an amount equal to or less than fair and thus make a good deal:
I – The price of the asset traded in the market is lower than fair;
II – Future dividends grow more than the market expects;
III – Interest rates fall;
IV – The dividend is actually paid as expected. As earnings can fluctuate negatively and, consequently, dividends, the market usually charges an average risk premium of 5% to cover this risk. If not, the premium charged is captured by you.

This item IV illustrates the fact that it is usually good business to invest at the height of a crisis. At this time, the premium charged by the market is usually higher. Therefore, you capture this prize as soon as the crisis passes. However, it is necessary to consider that it may last longer than expected, as has occurred in recent years.

Note that the 7% capital gain shown on line K in the figure represents expected profit growth. The capital gain is how much you should expect to earn from the change in the stock’s price. This means that if you pay fair value for a share, your total return (line L) will be given by the sum of the earnings growth rate and the dividend rate. Therefore, if profits grow more, you earn more, but if this does not happen as expected, part of what you earn in dividends can be lost due to negative price variation.

Thus, if you intend to invest directly in dividend-paying assets, you should consider carrying out four activities:
I – Properly estimate the interest rate and risk premium that covers uncertainty about future earnings;
II – Estimate the growth of profits and, therefore, of future dividends;
II – Project future flows of dividend payments;
III – Calculate the fair value of the asset.

If you do not dedicate yourself to carrying out and periodically monitoring these activities, the most appropriate thing is to enlist the help of a professional or research companies to guide you in this process.

Michael Viriato is an investment advisor and founding partner of Investor House.

Talk directly to me via email.

Follow and like De Grão em Grão on social networks. Follow the investment lessons in Instagram.

PRESENT LINK: Did you like this text? Subscriber can release five free hits of any link per day. Just click the blue F below.