For most UK stock market investors, 2018 was not a year to celebrate.
The FTSE 100 fell by 12% from 7,648 to 6,734, which left the large-cap index at levels first reached almost 20 years ago in 1999.
The FTSE 250 faired even worse, suffering a 15% decline from 20,681 to 17,587.
On top of that we’ve had a seemingly endless stream of fear-based highly negative ‘news’ from the financial and mainstream media. Most of this relates, of course, to the various dystopian futures which were may or may not be subjected to if Brexit ever actually takes place.
In such a negative environment, is there any positive news we can cling to, if only to maintain our sanity?
I think there is, and it’s this:
According to the dividend discount model, the FTSE 100 could be trading far below its intrinsic value
If that sounds like a load of gobbledegook, please allow me to explain.
Price and value are not the same thing
Although the FTSE 100’s price fell by 12% in 2018, its intrinsic value may have increased.
For the FTSE 100, you can replace the words ‘cash returns’ in the definition above with ‘dividends’.
So the intrinsic value of the FTSE 100 today is the sum of all its future dividends, with those future dividends discounted at an appropriate rate to take account of the monetary value of time.
When prices fall below intrinsic value, it’s time to celebrate
The idea that falling share prices are a good thing may seem a little counter-intuitive, so here’s a well-known quote from Warren Buffett on why this is indeed the case:
“To refer to a personal taste of mine, I’m going to buy hamburgers the rest of my life. When hamburgers go down in price, we sing the ‘Hallelujah Chorus’ in the Buffett household. When hamburgers go up in price, we weep. For most people, it’s the same with everything in life they will be buying — except stocks. When stocks go down and you can get more for your money, people don’t like them anymore.”
– Warren Buffett, Forbes magazine 2001
In other words, falling share prices allow you to buy a bigger slice of each company (or the market as a whole) for each pound invested.
More importantly, when shares and indices fall below their intrinsic value, the market is selling something for less than it’s worth.
For long-term investors that is unequivocally a good thing, although your inner monkey may disagree.
Note: If you’re a retired investor living off your dividends then falling share prices are neither good nor bad. But while falling share prices are no reason to celebrate, they’re no reason to panic either.
Estimating the FTSE 100’s intrinsic value with dividends
Unfortunately it’s impossible to work out a precise figure for the FTSE 100’s intrinsic value.
That’s because intrinsic value depends on future cash returns, and the future is ultimately unknowable.
However, there are various ways to estimate intrinsic value, one of which is knows as the dividend discount model (or the Gordon Growth Model).
According this model, we can estimate the intrinsic value (also known as the present value) of a future stream of dividends using a combination of the next dividend payment, a fixed (estimated) dividend growth rate and a fixed (estimated) discount rate:
- Intrinsic value = next dividend / (discount rate – growth rate)
Let’s fill in the blanks:
1) Estimate the future dividend growth rate
Since 1985, the FTSE 100’s dividend has grown by 6.1% per year, on average.
Lacking any deep insight into the future, I’ll assume future dividend growth remains at 6%:
- Dividend growth rate = 6%
1) Calculate the FTSE 100’s next dividend
On January 1st 2019, the FTSE 100 stood at 6,734 with a dividend yield of 4.68%.
We can use this to calculate a figure for the dividend at the end of 2018:
- 2018 dividend = 6,734 * 4.68% = 315 index points
And since we have an estimated dividend growth rate, we can use that to estimate the next dividend:
- 2019 dividend = 2018 dividend + 6% = 334 index points
2) Estimating the discount rate
The discount rate is effectively the long-term rate of return required (or desired, or expected) by investors, and we can estimate this rate of return using dividends and dividend growth:
- Desired rate of return = dividend yield + dividend growth
For example, if an investor buys the index with a 4% dividend yield and a 6% expected dividend growth rate, then we can assume that the investor’s desired rate of return is 10% per year.
In reality, since 1985 the FTSE 100’s dividend yield has averaged 3.3%.
If we combine this average (or ‘normal’) dividend yield of 3.3% with our estimated FTSE 100 dividend growth rate of 6%, we can estimate a ‘typical’ or ‘normal’ desired return for the FTSE 100:
- ‘Normal’ desired rate of return = 3.3% yield + 6% growth = 9.3%
In other words:
- ‘Normal’ discount rate = 3.3% + 6% = 9.3%
4) Value the FTSE 100 using the dividend discount model
Here are the numbers we have so far:
- 2019 dividend = 334 index points
- Estimated future dividend growth rate = 6%
- Estimated ‘normal’ discount rate = 9.3%
Now all we have to do is plug those values into the dividend discount formula to estimate the intrinsic value of the FTSE 100:
- Estimated intrinsic value = 334 / (9.3% – 6%) = 10,123
In this case, because we estimated the discount rate from dividend yield plus dividend growth, we can also use a shortcut and estimate intrinsic value by dividing next year’s dividend by the ‘normal’ dividend yield of 3.3%:
- Estimated intrinsic value = 334 / 3.3% = 10,123
And so, under a set of quite reasonable assumptions, the dividend discount model suggests that the FTSE 100’s intrinsic value is just over 10,000.
That means the FTSE 100, at today’s price of 7,134, is trading at a discount of almost 30% to estimated intrinsic value.
Can the FTSE 100’s intrinsic value really be as high as 10,000?
Obviously I don’t have a crystal ball, but yes, I think the FTSE 100’s current intrinsic value could be as high as 10,000.
Too many investors irrationally anchor their expectations of future prices to prices from the recent past.
For example, the FTSE 100 has been range-bound (approximately) between 3,500 and 7,000 for more than 20 years.
For entirely sensible reasons, we expect the future to look like the past (I expect fire to be hot because I have found fire to be hot in the past). But this doesn’t necessarily apply in the stock market.
The 20-year period mentioned above started in 1999 with the FTSE 100 at 7,000 and with a dividend yield of just 2%. At that point, the index was massively overvalued and had an estimated intrinsic value (according to the above dividend discount model) of just 4,300.
Today the FTSE 100 is still at 7,000 (7,134 at this exact moment) but the dividend yield is a much more interesting 4.4%.
So the index’s price hasn’t grown for 20 years, but its dividend has more than doubled thanks to an increase in productive assets (property, plant, equipment, etc.) fuelled by retained and reinvested earnings.
If investors today were as enthusiastic about the FTSE 100 as they were in 1999, its yield would be 2% and its price would be 16,700.
In that context, 10,000 is really not that high, and investors should get used to the idea that the FTSE 100 could exceed 10,000 in the next few years (although there are no guarantees, of course).
FTSE 100 forecast for 2019
Forecasting the stock market over a one year period is a fools game, so this is just a bit of fun. Although it’s still educational fun because the forecast should be based on rational numbers and reasonable assumptions rather than irrational feelings and beliefs.
Here’s my forecasting model:
And here are the relevant numbers:
- FTSE 100 price: 7,134 (12th Jan 2019)
- FTSE 100 2019 year-end intrinsic value: 10,730
The year-end intrinsic value of 10,730 is 6% higher than the current intrinsic value estimate of 10,123 because of the expected 6% dividend growth in 2019.
And so, finally, here’s my FTSE 100 forecast for 2019:
FTSE 100 2019 year-end forecast: 8,932
For the FTSE 100 to hit that forecast (which it obviously won’t hit exactly) it would need to go up by 25% from where it is today.
Is a 25% gain in the FTSE 100 really possible in a single year?
Yes, although it would be a bit of a stretch.
In the 34 years since 1985, the FTSE 100:
- went up in 24 years
- went up by more than 10% in 16 years
- went up by more than 15% in 8 years
- went up by more than 20% in three years
- went up by more than 25% in two years
So if these historic probabilities are even remotely reliable (which they sort of are), then the odds of the FTSE 100 reaching 8,900 in 2019 are about two in 34, which is not very good.
However, the odds of it going up by 10% or more are about even, and that would leave it at slightly over 7,800.
So although my theoretical forecast is for the FTSE 100 to reach 8,900 by the end of 2019, I think a more realistic forecast is 7,800.
And while as a value investor I realise that lower prices are better for accumulating investors, it would be nice to see the FTSE 100 exceed that forecast slightly and finally break the 8,000 barrier, if only for psychological reasons.