Fast-Moving Companies That Pay You Money to Own Them

We’ve discovered a way to use the time-proven tools of long-term investors to identify the next small stock superstars about to explode. You see, there is a traditional way that old-school investors and analysts look at their long-term holdings. To them, any stock is worth no more than what it will provide investors in current and future dividends. Guess what? We apply the same tried-and-true analysis using our Dividend Discount Model (DDM) to make stellar short-term trading profits, too.

Let’s take a step back: Dividends are by definition cash flows returned to the shareholder. They provide income on top of capital gains, which, using dividend reinvestment plans (DRIP’s), can be converted into more dividend-paying shares, thus creating a compound return on dividends themselves.

The DDM has consistently beaten the market over five-year time periods. The main reason is that it simply couldn’t care less what the market is doing.

The DDM allows investors to determine the absolute value of a particular company without looking at current stock market conditions. (In contrast, most analysts’ price targets based on the relative valuation of comparable companies.)

There’s another thing we like about the DDM: You can meaningfully compare stock valuations. Most of the time, analysts make their selections from a pool of stocks. They have so many things to take into consideration that a winner may be lost in the shuffle.

The DDM is only concerned with what investors can rake in from a company in future

cash flow. Using the DDM, an analyst can look at three companies: If the DDM churns out a value for one stock that is 97% higher than its current price, that will be the stock to pick.

There’s no pussyfooting around with the DDM. That’s why we like it.

Fine-Tuning the Formula

So how do we get results like this from the DDM? Here’s an example. Stain Resistant Ties Inc. pays a US$1.50 annual dividend. To formulate the future value of Stain Resistant Ties, we divide the annual dividend by the company’s discount rate, and then subtract its dividend growth rate.

Let’s say Stain Resistant Ties’ dividend grows at 3% annually. Using a discount rate of 6%, we can figure on Stain Resistant Ties trading for US$50.00.

The end figure will be Stain Resistant Ties’ full future valuation with dividends considered.

Since the model is highly sensitive to the assumptions made about growth rates and discount rates, performing a sensitivity analysis would be appropriate. Sensitivity analysis allows the investor to view how different assumptions change the valuation using the dividend discount model.

The dividend discount model is a good starting point for thinking about the valuation of a company.

Need more proof? Here you go…

Take a look at Anthracite Capital Inc. (AHR:NYSE). AHR pays a 9% annual dividend, which equals US$1.12 per share. Assuming AHR’s dividend will continue to grow steadily, we can crunch a few numbers and come up with a future value for AHR.

After throwing AHR’s figures into the DDM, we come out with a future AHR price of US$56.00. We simply divide AHR’s US$1.12 dividend by the 11% discount rate divided by the dividend growth rate of 9%.

Now you can easily see the future value of this company and the potential gains investors can make.