Before I start, let me reiterate that I’m a dividend investor and not a trader. So, I would write from the angle of an investor who plans to accumulate high quality dividend stocks to build wealth for the long-term. Thus, if you are a stock trader or a speculator, this write-up may not be suitable for you.

Here, let’s use a case study to address the question above:

## Case Study: A Ltd

For instance, we have A Ltd, a biscuit manufacturer that runs from 5 factories at Nation A and Nation B. In 2012, A Ltd reported \$100 million in net profits which worked out to be \$1 in earnings per share (EPS), based on 100 million shares. In that year, it declared and paid out \$50 million in dividends out of its net profits, which worked out to be \$0.50 in dividends per share (DPS).

EPS = Net profits / Number of Ordinary Shares
DPS = Annual Dividends / Number of Ordinary Shares

At a certain date in 2012, A Ltd was priced at \$10 a share. Hence, its share price was valued at P/E Ratio of 10 and dividend yield of 5% a year. To make it simple, let’s say I calculated its historical P/E Ratio and dividend yield and found both of these figures are fairly valued, not cheap and not expensive. For the sake of our discussion, let’s assume that I purchased shares of A Ltd at \$10 a share in 2012.

P/E Ratio = Stock Price / EPS
Dividend Yield = (DPS / Stock Price) x 100%

## Fast forward to 2021:

At that time, A Ltd doubled its number of factories to 10 in Nation A and Nation B. In the 10-year period, A Ltd doubled its distribution network and as such, the biscuit manufacturer reported consistent growth in net profits, growing to \$200 million in 2021. A Ltd kept its dividend payout ratio (DPR) consistently at 50% in the 10-year period. Thus, it had declared and paid out \$100 million in dividends in 2021. A Ltd’s number of shares remained constant at 100 million shares.

DPR = (Annual Dividends / Net Profits) x 100%

Presently, A Ltd’s stock price is trading at \$15 a share, 50% higher than the price I had paid for. So, should I sell A Ltd to realize a 50% capital gain from it?

Well, if I’m a shareholder of A Ltd, here is what I would do:

1. I’ll check its fundamentals. As stated above, A Ltd had grown its operations in the last 10 years and this led to a doubling of net profits and dividends over the 10-year period. In addition, I’ll find out if A Ltd is undertaking growth initiatives, such as construction of factory #11, expansion of distribution network and new biscuit product development, …etc that can sustain its future growth. If A Ltd is fundamentally solid and has growth initiatives, I would tend to keep its shares.

2. I’ll calculate its stock valuation. Hence in 2021, A Ltd is trading at \$15 a share. In that year, A Ltd’s EPS and DPS are as follows:

EPS (2021)
= Net profits / Number of Ordinary Shares
= \$200 million / 100 million shares
= \$2 a share

DPS (2021)
= Annual Dividends / Number of Ordinary Shares
= \$100 million / 100 million shares
= \$1 a share

Now, let’s assume that I continue to keep track of A Ltd’s P/E Ratio and dividend yield after purchasing the stock in 2012 for the next 10 years to 2021. Of which, I would have its historical P/E Ratio and dividend yield from 2012 to 2021. From them, its 10-Year P/E Ratio and Dividend Yield Average is 10 and 5% per annum, where both are the same figures as 2012.

So, it remains fairly valued if its P/E Ratio is 10 and Dividend Yield is 5% a year.

Based on \$15 a share, A Ltd’s current stock valuation is as follows:

P/E Ratio (2021)
= Stock Price / EPS
= \$15 / \$2
= 7.5

Dividend Yield (2021)
= (DPS / Stock Price) x 100%
= (\$1 / \$15) X 100%
= 6.7%

Thus, based on valuation ratios above, I would view A Ltd to be undervalued. I’ll not sell off A Ltd at \$15 a share, even if I can realize a 50% capital gain instantly. As a matter of fact, I would buy and accumulate more shares of A Ltd.

I would even view A Ltd at \$15 in 2021 is ‘cheaper’ than A Ltd at \$10 in 2012.

Here is another question, ‘What is the fair price of A Ltd?’

Well simple. First, A Ltd is fairly valued if its P/E Ratio is 10 and its dividend yield is 5% per annum. Thus,

P/E Ratio = Stock Price / EPS
Stock Price (Fair) = P/E Ratio (Fair) x EPS 2021
Stock Price (Fair) = 10 x \$2
Stock Price (Fair) = \$20

Dividend Yield = (DPS / Stock Price) x 100%
Stock Price (Fair) = (DPS 2021 / Dividend Yield (Fair)) x 100%
Stock Price (Fair) = (\$1 / 5%) x 100%
Stock Price (Fair) = \$20

So, the fair value of A Ltd in 2021 is calculated to be \$20 a share. If I sell A Ltd at \$15 a share, I would be disposing it off at 25% discount from its fair valuation. It is not a 50% capital gain to me, but rather a 25% loss.

Therefore, my decision in this case is not to sell A Ltd.

The above is a basic illustration of business valuation. If you find this concept as illustrated above difficult to understand, the best is not to invest first. I think it’s better for you to do some digesting of the above concept before investing.

Alright, that is it for this week.

If you have any questions / feedback, please post them to ian@kclau.com

Stay tuned for my latest next week.

Ian Tai

Financial Content Machine. Dividend Investor. Produced 500+ Financial Articles featured in KCLau.com in Malaysia and the Fifth Person, Value Invest Asia, and Small Cap Asia in Singapore. Regular Host and Presenter of a Weekly Financial Webinar with KCLau.com. Co-Founded DividendVault.com, an online membership site that empowers retail investors to build a stock portfolio that pays rising dividends year after year in Malaysia and Singapore.