A Fundamental Approach

Firm Foundation theorists use the fundamental approach to determine the intrinsic value discussed earlier. They look at several main determinants in their analysis of stock prices and future dividends.

Determinant 1: The Expected Growth Rate

In order to unuderstand Growth Rate one must understand how Compound Interest works:

If Jean-Paul invests a Principal, P, of $1.00 at a growth rate, r, of 5%

Present Dividend = $1.00 Dividend in n years = P(1 + r)^n

Thus we can draw following Table:

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Growth Rate    Present Dividend   Dividend in 5 yrs  Dividend in 10 yrs    Dividend in 25 yrs
  
        5 %	          $1.00	              $1.28	          $1.68	                $3.39
        10%	          $1.00	              $2.01	          $4.05	               $32.92
        25%	          $1.00	              $3.05	          $9.31	              $264.70

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Malkiel notes that many newly established coporations perish early. The ones that survive rapidly grow, mature, and then experience a period of stability. However, since it becomes increasingly difficult to sustain growth rates over time, many companies eventually ‘die out.’

Finally, Malkiel gives his First Rule, Rule 1:

"A rational investor should be willing to pay a higher price for a share, the larger the growth rate of dividends."

His Corollary to Rule 1:

"A rational investor should be willing to pay a higher price for a share the longer the growth rate is expected to last."