01-06-2015, 12:56 PM
The Chowder rule is an interesting idea to me (Initial Yield + Expected Growth Rate > 12%). I have been thinking about the relative importance a stocks Initial Yield versus its expected Growth Rate. I wanted to quantify their effects on the value you receive. To simplify things, I will assume dividends will actually smoothly increase exactly at the expected growth rate. I am also going to assume 1 yearly dividend to make my math quick (you can expand this method to semi-annual, quarterly, or monthly, but I am being lazy).
With the above assumptions, I believe we can use a modification of the equation for the present value of a growing annuity to give us a present value of future dividends.
http://www.financeformulas.net/Present_V...nuity.html
Generalized for our purpose:
PV = [(Initial Investment*Initial Yield)/(rate - Growth)] * {1-[(1+growth)/(1+rate)]^n}
Rate = the rate at which I am discounting future cash flows (usually a long term "risk free rate" such as 30 year treasury bond)
n = number of years of my time horizon
Note: make sure "rate" does not exactly = growth to avoid a nonsensical result
I played around with this for a while. Looking at the Chowder rule line where yield+growth=12%, it is interesting to see yield be more important as "rate" goes up and growth become more important as "n" goes up. Since I am interesting in long time horizons, I plugged in a large number (50) for "n" and varied my "rate" from 1% to 6% to find where I find the best returns. The sweet spot appears at a yield around 3-3.5% with a growth of 9-9.5%. Of course having a combined initial yield and growth above 12% is always better.
In the end, I found that going to far extreme with (low yield/high growth) or (high yield/low growth) is worse than (moderate yield/moderate growth).
As a side note, you could use the equation for the present value of a growing perpetuity if you were assuming you never sell the stock, but only if "rate" is greater than Growth.
http://www.financeformulas.net/Present_V...tuity.html
With the above assumptions, I believe we can use a modification of the equation for the present value of a growing annuity to give us a present value of future dividends.
http://www.financeformulas.net/Present_V...nuity.html
Generalized for our purpose:
PV = [(Initial Investment*Initial Yield)/(rate - Growth)] * {1-[(1+growth)/(1+rate)]^n}
Rate = the rate at which I am discounting future cash flows (usually a long term "risk free rate" such as 30 year treasury bond)
n = number of years of my time horizon
Note: make sure "rate" does not exactly = growth to avoid a nonsensical result
I played around with this for a while. Looking at the Chowder rule line where yield+growth=12%, it is interesting to see yield be more important as "rate" goes up and growth become more important as "n" goes up. Since I am interesting in long time horizons, I plugged in a large number (50) for "n" and varied my "rate" from 1% to 6% to find where I find the best returns. The sweet spot appears at a yield around 3-3.5% with a growth of 9-9.5%. Of course having a combined initial yield and growth above 12% is always better.
In the end, I found that going to far extreme with (low yield/high growth) or (high yield/low growth) is worse than (moderate yield/moderate growth).
As a side note, you could use the equation for the present value of a growing perpetuity if you were assuming you never sell the stock, but only if "rate" is greater than Growth.
http://www.financeformulas.net/Present_V...tuity.html