January 2012
How do you value income?
Capital that does not produce income is pretty much worthless. What about Berkshire Hathaway, Apple or gold many will shout? The truth is that no one is more aware of the importance of dividends than Warren Buffett. That is why he doesn’t pay any. In the case of Apple, and many other technology companies, the executives know that product cycles are getting shorter and shorter and that they need to conserve cash to develop the next product. And there is no guarantee it will sell as well as the last one. Ten years ago markets valued Nokia and RIM at 50 years of such earnings. Now, they are struggling to adapt to a re-vitalised competitor that itself was near extinction just fifteen years ago. The argument for gold is simply that while it might have a negative nominal yield it has a positive real yield as inflation preserves its value.
In any event these examples are at the fringes of most people’s portfolios. What matters most to the average investor is how to split a portfolio between bonds and equities. There are all sorts of rules of thumb on this and the growth in asset allocation strategies, some driven by cash flow forecasts, has made it an increasingly important topic.
At the core of the argument, and looking at things in a purely UK context, is how much value should be placed on the £47 billion of income that HMG pays out on its borrowings compared to the £76 billion of dividends generated from companies in the FTSE 350 Index. In other words if equities provide 62% of the£123 billion income stream should they form 62% of the assets? As 2011 evolves into 2012 the relative valuations are vastly different. While the nominal value of UK sovereign debt stands at £1 trillion its market value is higher at £1.138 trillion. Contrast that to the current £ 1.73 trillion market value of the FTSE 350. In total these two markets are valued at £2.868 trillion of which 60% is in equities.
Those figures must be accurate because there is an army of brokers, fund managers, journalists, commentators and rating agencies looking at the data every second of the day. That is not to say though that it won’t change.
We know that debt payments from HMG are going to rise to about £60 billion over the next five years because the OBR has told us that on the basis of the projected 50% rise in net public debt. There is though no consensus of what dividend payments from UK Plc might be over the same time scale.
There is one other factor we can put into the equation and that is inflation. While we don’t know how much it will be, we do know it will exist. For the sake of argument let’s assume it totals 10% over the next five years. That is pretty much what index linked gilts are telling us it will be. Let us also assume that earnings, and hence dividends, will match inflation so UK dividends will rise to £84 billion.
On that basis the relative positions of the two income streams will change a little. In five years time dividend income from UK corporations will fall slightly in relative terms to 58% of the £137 billion of total income.
Trying to extrapolate a capital value for these capital markets from such a hypothetical exercise is almost futile, but not quite. But let’s do it anyway. Forecasting the size of the gilt market in five years is easier because the Office of Budget Responsibility predicts that it will grow by 50% in nominal terms. That would take it to £1.707 trillion. The big question is where will that additional capital come from? Will it be from equities, overseas markets or internally generated growth? It is certainly a lot of capital to find and there is the risk that the massive expansion in gilt issuance could just crowd out equities by depressing yields across the board and leave capital values where they are, or even lower. However, even in that worst case scenario equity income would still be a lot higher than gilts in relative and nominal terms.
To maintain the relative positions, i.e. for equities to still represent 60% of the total capital the FTSE 350 would need to rise to £2.3 trillion or 35%. If mimicked by the FTSE 100 it would represent a value on that index of over 7,600.
An alternative method is to use yield to compare two income streams. At the beginning of 2012 gilts yield 2% and equities 3.8%. As these two markets evolve, and equity income becomes larger than interest income, it is reasonable to postulate that it will become even more valuable. In other words its yield will fall. If, for the sake of argument, it fell to the 2% level that 10 year gilts now trade at it implies a 90% uplift in the capital value of the underlying assets. That would take the FTSE 350 up from today’s level of nearly 2913 to 5,535. Expressed in the more familiar language of the FTSE 100 it implies a rise from 5,500 to 10,450. How’s that for a New Year’s wish?