In this video we conclude our discussion of the Dividend Pricing Model
VIDEO SUMMARY
In this video we are going to continue talking about the Dividend Pricing Model. What I want to do in this video is talk about the implications of the model. In the previous videos we talked about the equations, how to calculate the equations, and how to use them in financial decision-making. What I would like to do is just stop and take a step back and talk about what this equation really means. What does it mean for you? Because it is quite significant. I do not know how you can look at this mathematical formula and not jump out of your chair in excitement, because the statement this formula is making is so powerful, it is so bold, that it is really quite exciting.
The concept is that the value of a potential investment is a function of the expected cash flows you are going to receive, discounted by risk. So if you are an organization or a company and you expect to generate a certain level of cash flow each year out to the future, those cash flows are discounted by the perceived risk of your organization and that determines the price someone is willing to pay. So what does that mean? That is a pretty bold statement because if that is true, then you can increase the value of your organization by decreasing the risk. Just think about that. So if you have two companies and these companies are exactly alike: they produce the same amount every year, they have the same level of technology, the same number of people, the same costs, exactly similar companies except one difference: one company is more fiscally responsible. One company has the perception of less risk than the other company. If an investor is looking at those two alternatives and looking at buying one of these companies, they are willing to pay a higher price for the less risky company. It is because they are discounting less for risk. That is what this equation is saying. Well that is pretty powerful stuff.
Let us look at what that means when I say less risky. What does that mean that your organization would be less risky? Well that could mean a couple of things. It means you have a stronger financial position. It means you have more reliable earnings. It means you have less exposure to risky markets. It means you have a stronger credit rating. It means there is confidence that you have accurate reporting. It means you have strong internal controls. It means you have a history of strong performance. It means you have a strong brand image. And it means you have a strong competitive advantage. All those things could mean that your organization is less risky and therefore someone is willing to pay more money. Now I am not saying that your goal here should be to limit the risk exposure of your company to zero. That is not the goal here. If you are a company, you are not going to achieve the same risk rating as say a government-backed security that is going to be much less risky than a company. But that is not the point. The point is, and this is relevant no matter what type of organization you are, there are always opportunities to improve your level of fiscal responsibility. There is always some way you can ratchet up the level of your financial awareness and have stronger financials and stronger financial processes, and when you do that, it increases the value of your organization. It can be pretty significant because, according to this formula, a one percent decrease in risk is one percent less that your cash flows are going to be discounted.
Let us look at this in the example of a city. So a municipality issues muni bonds and the city will issue a bond it will get the money from investors and will pay off those bonds over a long period of time. The city will use this money to make investments for the community. They will build roads. They will build bridges. They will build schools. All really great stuff for the city. But they have to pay this money back. Not only that, they have to pay the money back with interest and they pay that interest rate based on their riskiness as an organization. So the more risky they are, the higher their interest payments are going to be. If they can lower their riskiness as a financial entity, their interest payments are lower and they can spend more money on building bridges, on building roads, on building schools. So it can be very powerful. And these bonds are pretty large amounts of money. So a small percentage change over a 20-year period adds up to a lot of money.
Let us look at an even bigger example. Let us look at society. Society as a whole. Just taking the United States, the GDP of the United States at the time I am shooting this is around 16.8 trillion dollars. That is gross domestic product that gets produced every year. If we take one percent of that, we are talking about a hundred and sixty seven billion dollars. That is the impact of financial responsibility and the impact of decreasing riskiness by 1%. We are just talking about a small change here. If you just think about the people in your lives, we all know people that have room for financial improvement. There are people who cannot balance their budgets. There are people with credit card problems. There are people who have trouble living within their means. That is just on the low end. We all have room to improve our financial positions. So if we all as a society just increased our financial awareness just a little bit, the impact would be huge. We would not have to change anything else about our lives, but if we improve the financial decisions we make, the value of everything in society goes up. Because here is what happens. Investors are using this formula all over the world to make investment decisions and there is a finite amount of investment dollars out there. Investment banks have a designated amount of money that they are looking to invest and they are looking at all these opportunities. What they are doing is they are discounting opportunities based on risk. Well if opportunities are less risky, they are going to discount those prices less for that risk. So those investment dollars out there get stretched farther and we all get more money in our pockets. That is how this works, and that is why this is so powerful.
Let us bring this back to you, because this all comes back to what you can do. This equation should be very empowering to you because it shows that you can improve your financial decisions and you can create value in your own life. Banks and financial institutions are looking at you and assessing you this way. We all have a credit score and that credit score is based on your level of riskiness. The better your credit score gets the more financial opportunities become available to you for precisely the reason of this equation because you are discounted less for a level of uncertainty when banks look at you. So the main takeaway here is that there is an enormous amount of wealth that could be unlocked as we improve our levels of financial awareness. And how do you do that? You do that through financial education. You do that through learning. You do that through making better financial choices. And if we can all do that, if you can do that in your company, if you can do that in your jobs, if you can do that in your personal lives, there is a huge amount of value that we can create in society and we do not have to do anything. We do not have to work harder. We do not have to invent new technologies. We just have to make better financial decisions, and it is all because of the Dividend Pricing Model.
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Neither Zach De Gregorio or Wolves and Finance Inc. shall be liable for any damages related to information in this video. It is recommended you contact a CPA in your area for business advice.