Given my background and because a number of our members are investment professionals (including Chartered Financial Analysts), I tend to write about investment-related topics fairly often. My perspective on the world is to some extent coloured by my investment training, and I think a number of investment topics have applicability more broadly too – including the focus of this post: our own growth rates.
I also wrote about models (such as financial models) being representations of reality in our post on Professional & Personal Development Cycles. One of the central models in investments is the Dividend Discount Model. It is used, along with other more complex techniques, to value the shares of a company. It is based on the theory that a share is worth the sum of all the company’s future dividend payments, discounted back to today i.e. the net present value of the future earnings that holders of the shares actually receive as dividend payouts.
Read more to explore this valuation model, think about intercepts, slopes and reinvestment, and consider with us a thought experiment on our own professional growth rates and future earnings. Please do build on the ideas mooted in the comments.
Valuing the Future
Models that discount dividends are “absolute valuation” models (as opposed to “relative valuation” models). They aim to find the intrinsic value of an investment based only on that share’s fundamental characteristics such as dividends, the growth rate for that company, its cashflow, its assets etc.
The Gordon Growth Model is a formulaic example of the Dividend Discount Model, and it relies on three inputs/parameters:
There are a number of implicit assumptions in the Gordon Growth Model – this is to be expected given its simple formulation. For example: it assumes that dividends are earned in perpetuity, it assumes they are stable and grow at a constant growth rate, and it doesn’t allow for decay in earnings e.g. if the industry is in decline or the products are becoming obsolete over time. This last point can be adjusted for by reducing the growth rate i.e. dampening the growth in some revenue streams by offsetting the decline in others. Dividend Discount Models also don’t naturally suit companies that don’t pay dividends.
Intercept, Slope and Reinvestment
Another way to think about the model is as a function/graph with dividends as the ‘intercept’ and their growth rate as the ‘slope’. The most desirable situation would be a high growth rate / slope and a high starting point / intercept.
And, an interesting extension is to consider that the dividends and the growth rate are both impacted by the reinvestment ratio i.e. the proportion of earnings reinvested into growing the business (and hence its future earnings). A higher reinvestment ratio means less dividends now (i.e. less of the earnings are received by shareholders now), but better growth in earnings (and hence dividends) in future, if the retained earnings are invested in successful growth projects.
A Thought Experiment
So now that I’ve set out the Gordon Growth Model of share valuation, the thought experiment that is the focus of this post is as follows: what if we think of ourselves this way? In other words, dispassionately look at our own ‘value’ as merely the present value of our future earnings? Admittedly there is much, much more to our lives in reality, but all models are oversimplifications. There are many intangibles that contribute to our career fulfilment (and broader fulfilment) than simply the paycheck we receive. Putting those aside though, what could we learn from this thought experiment?
Some ideas – please do add yours in the comments below: