John Burr Williams’ family could trace their lineage in North America back to the first English settlements. He made a significant contribution to the investing world but he was not the only family member who left a mark.
One relative founded Princeton University and had a son who became Vice President of the United States. He was the first of two sitting Vice Presidents to shoot someone while in office. One-upping Dick Cheney he managed to kill his victim. The ‘Burr’ in John Burr Williams was the surname of his infamous forebearer Aaron Burr who killed Alexander Hamilton.
John Burr Williams’ contribution? He invented the dividend discount model. Nobody is going to make a hit Broadway musical with a climactic scene involving the discounting of future dividend payments. Yet that doesn’t mean we should ignore Williams’ contribution.
The search for intrinsic value
John Burr Williams’ story is remarkably similar to his contemporary Benjamin Graham who would later write the Intelligent Investor and teach Warren Buffett how to invest. Williams worked on Wall Street during the 1920s and grew disillusioned with the excess of the market prior to the crash of 1929.
He returned to Harvard to get his PhD in Economics and studied the crash and subsequent depression. His conclusions on what went wrong and how to fix it were captured in his thesis which went on to be published as a book called The Theory of Investment.
His conclusion was that investors needed to focus on the intrinsic value of shares to prevent speculation. Sound familiar? He came up with this 11 years before The Intelligent Investor was published.
Dividends and speculation
Benjamin Graham was one of the early reviewers of The Theory of Investment. In his review Graham wrote:
“The emphasis on the primacy of dividends and the insistence that the value of reinvested earnings is to be found only in increased dividends sound a much-needed warning to Wall Streeters.”
Graham and Williams shared an abhorrence for speculation. Williams wrote his book, and Graham the review, in the depths of the great depression and one of the worst market environments in history. This context matters.
They were looking for someone to blame and turned their sights on the speculators who dominated the market in the 1920s. This idea of wanting to separate yourself from blatantly ridiculous behaviour makes complete sense to me.
I did the same thing when I became an income investor after the .com bubble burst. I was looking for something tangible that made sense to me after all the meaningless hype. Income investing is methodical, long-term and boringly effective. The perfect contrast to speculation.
Williams agreed and his definition of what separated an investor and a speculator also involved dividends. To him an investor was “a buyer interested in dividends.” In Williams’ opinion this contrasted with a speculator who was just looking for rapid price appreciation.
All these years later the question is simple. Are Williams’ views relics of a bygone era? Can his world view hold up in the age of meme shares, the mostly dividend allergic magnificent seven, and $TRUMP coin?
Is the dividend discount model still useful?
We don’t hear much about the dividend discount model anymore. Yet it forms the basis of how we value almost everything today. The dividends were simply replaced by cashflows.
Williams did not agree with this. He even wrote a poem about dividends. Seriously. I’m not kidding.
“A cow for her milk
A hen for her eggs,
And a stock, by heck,
For her dividends.
An orchard for fruit,
Bees for their honey,
And stocks, besides,
For their dividends.”
He isn’t exactly T.S. Elliot. But it is kind of catchy.
In his poem Williams was pointing out that there are many things in life whose value is dependent on what you can sustainably and consistently get from them. In his view a stock is the same. It is only worth what you can get out of it. I feel the same way.
Investing is often portrayed as an activity that only comprises the twin milestones of the purchase and sale. Obviously, the prices on those days matter. But as a long-term investor the periods in-between matter too.
It is in this no man’s land between a purchase and sale that dividends can improve your life. They can bring you security by providing cash to spend without drawing down principal. They can provide dry powder to take advantage of investment opportunities. They allow you to bank returns in the face of an uncertain future.
A dividend is how the company you partially own makes your life better without having to rely on the vagaries of how much somebody is willing to pay for your ownership stake when you want / need to sell it.
To me that is valuable. For others it may not be. But if you agree with me - and more importantly, Williams - it should factor into the way you evaluate an investment.
How to use dividends to help evaluate a share
Critics will be quick to point out several challenges with a dividend discount model. They include:
- The model can only be used on mature companies that pay dividends.
- The model is only as accurate as the estimates of future dividends. Once again, this favours mature companies in non-cyclical industries that have narrower ranges of future outcomes. These factors make dividends more predictable.
- The model is highly sensitive to the discount rate.
I’m not particularly concerned with any of these issues. The second and third critiques apply to any discounted cash flow model. Plus, I buy mature companies in boring and predictable industries that pay dividends.
I also don’t create elaborate models. I don’t have the time or interest for that. I make a back of the envelope estimate of what a share is worth – to me. My goal is to create a stream of passive income that grows faster than inflation. Therefore, I focus on estimating future dividends.
To do this I look at the dividend projections from our analysts and I look at the dividend history.
The place I spend my time is trying to understand the company, the competitive environment it operates in, and the overall direction of the industry. This will have the biggest impact of future dividend growth over the long-term.
Final thoughts
I can picture finance professors and professional investors rolling their eyes. They’ve relegated the dividend discount model to the dustbin of history and they would likely be appalled at my back of the envelope approach.
I know all the reasons why they would object to what I’m doing since I was taught the ‘right’ way to value a share during my MBA studies and the Chartered Financial Analyst exams. I would guess the biggest complaint is using dividends in a valuation and ignoring the full cash flows generated by the business.
In my mind – and Williams' – the purpose of all those other cash flows is to grow future dividends. That means they are accounted for in the model because it includes future dividends.
The impact of these cash flows are simply delayed which makes it more conservative. This is the argument Graham was making in his review which I quoted earlier.
It is easy to get caught up in the theoretical debate on valuations. But all I’m trying to do is live my life and hope my investments pay off enough for me to have a decent retirement. Maybe turn left at some point boarding a plane.
I try to understand the companies I buy. I leverage the work of our analysts. I do some simplistic calculations. I focus on what is important to me as an income investor.
This is all a means to an end and you don’t win any points for complexity.
Mark LaMonica, CFA, is Director of Personal Finance at Morningstar Australia.