2. The Market's Time Horizon

To see whether the market assumes a long-term perspective when valuing firms or assets, let us look at a real life example: Novartis, one of the world's largest pharmaceutical companies.

In November 2016, the stock of Novartis was trading at a price of CHF 68. We know that the stock price corresponds to the present value of all expected future dividend payments.  Now let's assume the following:

  • The last annual dividend paid by the stock was CHF 2.7 
  • The market expects dividend payments to grow by 1% in the future 
  • The firm's cost of equity is 5%
  • The market applies the Gordon-Shapiro model when setting stock prices, that is, the market assumes that future dividend payments take the form of a growing perpetuity.

 

With this information at hand, we can actually replicate the firm's stock valuation as of November 2016:

 

Stock price = \( \frac{Div_0 \times (1+g)}{k_E - g} = \frac{2.7 \times 1.01}{0.05-0.01} \approx 68 \).

 

But what exactly does this tell us about the market's time horizon? If the market expects the future dividends to grow at 1% and the cost of equity is 5%, we can actually forecast these dividend payments and compute their present value. The following table does this for the next 5 expected dividend payments (years): 

 

Expected Dividend

Present Value @ 5%

Dividend 1

2.73

2.60

Dividend 2

2.75

2.50

Dividend 3

2.78

2.40

Dividend 4

2.81

2.31

Dividend 5

2.84

2.22

Total

12.03

 

According to the numbers in the table, the cumulative present value of the next 5 dividend payments is 12.03. Therefore, the cash flows the market expects the stock to pay over the next five years only account for 12.03/68 = 17.7% of the stock price! Put differently, more than 80% of the value ascribed to the stock by the market arises from expected cash flows beyond year 5. Clearly, forecasting cash flows for only 5 years will therefore not produce a meaningful valuation!

 

The following graph replicates the preceeding analysis for a much longer time horizon. The key take-away is that, conditional on the model's assumptions, almost 50% of the stock price result from expected dividends that are more than 20 years in the future!

 

 

Clearly, this section shows that the market assumes a (very) long-term perspective when valuing assets. It is therefore crucial to think beyond the "explicit forecast period" and make meaningful assumptions for "continuing value."