Calculating intrinsic value for business with earnings partly reinvested and partly redistributed as dividend

This is in response to a fellow value investor, Jojo, who asked if it is better to take into consideration of dividend payout in calculating the intrinsic value. Again, I agree with her view if the business you are evaluating does have a dividend policy. I mean whether you calculate your intrinsic value by either way - that is 1) the company does not give out dividend and reinvest every penny or 2) the company gives out part dividend and reinvest the rest - the basics in calculating the intrinsic value are the same. The difference is you get a more accurate outcome if you can manage to make an intelligent guess that will be close to what will happen in the future.

Before going further, what I did before was just a very very rough estimation, just a general guideline. And I am glad you pointed out about how dividend can affect the outcome of the intrinsic value which I totally agree. I gave it some thoughts earlier but did not go further than having the thoughts. Now that you pointed out, here is what I did and the outcome is like what you say, it is definitely very different if all earnings are reinvested.

If we put the exact same principle of intrinsic value - which states that intrinsic value is a value which is all the cash and earnings, irregardless of it given out as dividend or retain in the business, that an investor will receive in the future, discounted at an appropriate interest rate back to today - to use, the basic notion is still the same.

In the same example as given earlier in Walgreen, there will be two parts to the intrinsic value if I calculate the intrinsic value based on the business having a dividend policy.

The first part is the intrinsic value of the capital gain for the timeframe that an investor has, for my case, it is 20 years. This capital gain has accounted for all distribution of dividend that are paid out, that means calculation here is based on earnings that are reinvested.

The second part is the intrinsic value of all the dividend that an investor would receive, discounted back to today.

Here is how it is calculated. The variables needed are: 1) 2006 book value is $9.92, 2) ROE is 19% and 3) dividend policy is estimated at 15% payout of earnings.

In 2007, the business will earn $1.88 ($9.92 x 19%) per share. Out of this $1.88, the dividend given out will be $0.28 per share. Therefore, at fiscal ended 2007, the book value will result as $11.52 ($9.92+$1.18-$0.28) per share. So to estimate the intrinsic value for 20 years, all you need to do is the repeat the process for another 19 times.

After you have repeated that process up to the 20th year, you will get a book value of about $198.11. The intrinsic value for this gain in book value between this 20 year investment timeframe will have to be deducted with the earnings you would otherwise have earned in an alternative risk-free investment like bonds. So the earnings from the reinvested capital which results in the growth of the book value from $9.92 to $198.11 is $188.19. Then you have to deduct this earnings from reinvested capital from the earnings from bonds of $74.42. This results in an intrinsic value of a future amount of $113.77. And then you have to discount it at an appropriate interest rate (5.25%) back to today value, which results in an intrinsic value of $40.88 at today value for the gain in reinvested capital.

And also, you will have a list of all the yearly dividend that are given out yearly - $0.28 in 2007, $0.33 in 2008....$0.94 in 2015...and $4.86 in 2026. Remember all these future dividend cash outflow to an investor is at a future value. Again you must discount it back at 5.25%. The dividend received in fiscal ended 2007 of $0.28 is worth about $0.27 today. The dividend received ended in 2008 of $0.33 is worth about $0.30 today. In 2015, the dividend of $0.94 is worth $0.59 today. In 2026, the dividend of $4.86 is worth $1.75 today. So now you have to add up all these future cash dividend flow for all the 20 year you would expect to receive, it results in a total intrinsic value of $16.02 for all these 20 years of dividend cash flow.

So what is the intrinsic value of the business? You have to add both the intrinsic value of the reinvested capital of $40.88 and the intrinsic value of all the dividend cash flow of $16.02. It gives you a total of $56.91.

So at the price I bought which is $41, that equates to paying 72% of all the future 20 years of cash flows. In other words for every present value of dollar for the next 20 years of cash flow, I am getting a 28% discount for each dollar at today value for the future.