The past performance of a security or asset could be seen in terms of the dividends or returns that it has provided in the past. This is also called the rate of returns of the company. This is made up of several constituents, viz. inflationary trends, liquidity, and also compensation in terms of other risks that investors need to bear.
Models for assessing past performances of assets/security
There are quite a few models that assess the past performance, notable among which are the Capital Asset Pring Model, the Dividend growth model, Price-earnings model, Dividend yield model. (Rates of return and valuing assets n.d.).
Dividend Growth model
It is seen that one of the best methods is called the Dividend growth model, which assesses the Returns on capital investments and expected capita. In this case, the value of a stock or its assessment could be seen as follows:
Dt = Expected dividends at the end of the year
P0 = Actual market price of stocks
Pt = Expected price of the stock at the end of each year
g= Growth rate in the dividends over some time
The assumptions that the Dividend growth model infers is about:
- The current dividend.
- The expected growth of dividends.
- The rate of return on the stocks.
Dividend growth Model: (Dividend growth model 2008)
What are the strengths and weaknesses of these methods
The Constant Dividend Growth Model could be used for calculating both dividends as well as bond interests, in terms of its future trend analysis.
However, one of its weaknesses is that the rate of discounts must be higher than the earnings growth rate, which may not always be true in the short term (Rates of return and valuing assets n.d.).
The price-earnings ratio provided a comparison between two firms in the same kind of business in the same industry, in terms of how earnings trend for the future is envisaged. It could provide data on the efficient performance of one firm against another. However, the price-earnings or P/E ratio cannot compare different kinds of firms in diverse types of industries. and it could also be inconsistent over time and economic vicissitudes.
Again, it could be seen that dividend yield could be useful in assessing the valuation of firms and is a reasonable valuation. However, “this does not necessarily mean that corporations can increase their stock prices by simply raising the current dividends. Shareholders care about all dividends, both current and those expected in the future.” (Brigham & Ehrhardt, p. 391).
A low dividend yield could be interpreted in two ways- the company has low earnings or it may be building future reserves for future growth and higher dividend payouts in the future. “So, when you select a company you should check not only its dividend yield but also the history of steady growth and earnings and predictions on the revenue growth. “ (Dividend yield calculation and drawbacks 2008).
When can we use the past to make an assessment, when is it less useful
In terms of assessing the valuation of assets/security, it is necessary that past can be used as indicative of future, when the business climate remains, more or less, the same. Also in cases where optimum capacity utilization has already taken place and there is not much scope for further business expansion, except for diversification plans. In such cases of low risks and challenges, it becomes necessary to use past prototypes to judge the future, especially when no major structural changes are envisaged. In the event business climates fluctuate, and recession or economic meltdowns begins to occur, as, in the present global scenario, it would not be feasible to judge the future, based upon past economic trends.
It is seen that economic trends are fast-changing, and it would be more appropriate to judge the future on sound and scientific theories based on empirical evidence, rather than hypothetical analyses, or biased judgments.
Further, it is seen that changes in laws and regulations have important implications for many industries. (Brigham & Ehrhardt, p.100).
The free enterprise that was propounded in earlier years, which has underpinned success in many fields of economic endeavors, may be more closely controlled in the future. If the tobacco industry is taken as an example, the risks of future legal restrictions need to be taken into account while making business expansion plans. Similarly, the telecommunications, electronic, and energy sectors would be a focus for major expansion and growth, due to accelerating demands and the need for large-scale developmental activities in these areas. Similarly, automobiles, housing, and education would be major thrust areas in the future and it would not necessarily respond to past performances or trend analysis. In such cases, it would become necessary to take into account, all aspects, economic, or otherwise to respond in such matters.
Thus it could be said that the past could be indicative of the future when there are consistencies in economic growth and lower margins for calculation errors. Also, aspects like the kind of industry, its track record and past performance, risk factors, and compliance with industry-specific regulatory norms are also of major importance.
When major impediments are present it would be judicious to seek other tools to assess future performances.
- Brigham, E F &. Ehrhardt, M C n.d., Dividends and earnings growth: financial management theory and practice, 10th edition
- Dividend growth model. 2008. FionPlan.
- Dividend yield calculation and drawbacks: dividend yield as a stock selection criterion. 2008. Stock Market Investors.
- Gordon growth model. 2009. Investopedia. Web.
- Rates of return and valuing assets: IS lecture: week 2. n.d. Web.