Opinion – Grain in Grain: Find out how to value a stock or FII through its dividends

Most investors do not understand the real relationship between the dividend and the price of an asset. Understanding this relationship is essential to analyze the impact of economic variables on the price of the asset. I explain below the factors that affect the price of a stock or a real estate fund (FII).

The price of a stock or a real estate fund can be interpreted as a “interest-bearing vault” in which all the dividends that will be paid for the rest of the asset’s life are kept.

That’s right, the price already includes all future dividends to be received. I will explain with an example of FII. But for actions the same reasoning can be applied.

In a simplified way, the fair value of an asset can be explained by three factors: the value of the dividend in the next period, the growth rate of these dividends over the years and the interest rate to discount the dividends to present value. Let’s start with an example for the first two variables.

Consider an FII that expects to pay BRL 8 per share in dividends within a year from today. Let’s call the instant of this first payment Year 1.

Assume that this dividend grows with expected inflation of 6% per year and an actual growth rate of 0.5% per year.

This real growth rate can be estimated by the manager’s ability to find properties that are in high demand and, therefore, their rents may appreciate more than inflation in the long run. For a stock, it would represent the company’s ability to annually increase the quantity of products sold or improve the selling price above inflation.

With growth of 6.5% per year, in Year 2, the dividend per share will be BRL 8.6, then it will rise to BRL 9.2 in Year 3, BRL 9.8 in Year 4 and continue to grow at this rate for the next 300 years, for example. The table below presents these dividends in the second column up to the twentieth year.

Can you imagine what the dividend per share of this FII will be in the Year 200, following this growth rate of 6.5% per year?

In Year 200, the dividend will be R$5,629,395.3. Calm down, how would this mountain of money fit within the current price? What should be the value of the quota of this FII to fit all this amount?

It happens that the value stored in the “safe”, that is, in the price, is not exactly this amount, but its present value.

Imagine that you have R$ 6.96 today. You can invest this resource at an interest rate of 15% per year and it will turn into R$8 in one year. If you have R$ 5.6 and you apply it at an interest rate of 15%, you will have R$ 9.8 in 4 years. And, if you have BRL 0.000004 and you apply it at 15% per year, you will have BRL 5,629,395.3 in 200 years.

The present value of the dividend in Year 1 of R$8 is R$6.96. Likewise, the present value of the dividend in Year 200 is only R$0.000004. Is it clear that the present value of each of the dividends drops significantly over time? This is a reflection of the composition of interest over time.

Thus, the value stored in the “interest-bearing vault”, that is, in today’s share price, is just the present value of these dividends. The table above presents the expected dividend and its respective present value up to the sixteenth year.

When we add the present value of all dividends, we find the value of R$100 per share in this example.

Considering the dividend of BRL 8 and the price of BRL 100, we can calculate the indicator that is very closely monitored for those who invest in FIIs, the Dividend Yield (DY), or Dividend Rate.

The DY of this FII would be 8% per year (= BRL 8/ BRL 100). This dividend rate is similar to that of logistics FIIs currently traded on the market.

As this price is the “paid vault”, every time a dividend is paid, this dividend amount comes out of the vault and therefore the price drops in value at the moment.

For example, at the end of Year 1, just before you receive the dividend, the value of the FII would be R$115. The next time the dividend is paid, you have R$8 in your pocket and a share worth R$ 107. The sum of the two values ​​is equal to the price just before payment. This is shown in the figure below, in the lines identified as VIII, IX and XII.

The amount of R$107 (in Year 1 and line VIII) is found by adding the present value of the 299 dividends still to be received.

The price of R$100 is the current fair value of this FII, as it represents the present value of all dividends you will receive in the future. The traded market price may be equal to or different from this fair value.

If the price traded on the market is equal to the fair value, you will earn income, annually, the percentage equivalent to the interest rate that discounts dividends to present value. In our example the rate is 15% per year. Part of this income is received in the form of dividends and part in capital gains. In our example, 8% is the dividend gain and 7% represents the capital gain.

See that the dividend gain, contrary to what many believe, is not additional to your total gain, but is part of it. And this total income is defined by the discount rate.

If the traded market price is less than fair value, your expected yield will be greater than this discount interest rate.

Note that the definition of this discount rate is very important. You can determine it by estimating three variables: expected inflation, real interest rate, and risk premium. See the example we used in the figure above in the lines identified from I to III.

The first two factors can be extracted from market expectations. The risk premium is the only one you will have to define yourself.

For real estate funds, a risk premium between 2% and 3% is quite reasonable for the security of receiving the flows.

In the case of equities, as there is greater uncertainty about future dividend flows, this risk premium should range from 3% to more than 8% per year.

I created a spreadsheet for you to simulate the price of assets by changing these factors that we mentioned. The spreadsheet is available at this link. The cells you need to change are the ones identified in yellow. This is an example of what is called a discounted dividend model for valuing stocks and real estate funds.

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

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