CHAPTER 3
Valuing Uncertain, Perpetual Income Streams
The next step generalizes the lessons we learned in our analysis of Treasury Inflation Protected Securities (TIPS) and extends the analysis in three key ways.
1. We consider that the cash flow to investors may be expected to grow at a rate different from, typically higher than, the underlying inflation rate.
2. We present a mechanism for how corporate capital spending produces expected inflation-adjusted growth.
3. We introduce the concept of uncertainty.
This last consideration is actually the easiest to treat, so we will deal with it quickly and then move on to the other matters. Throughout the rest of the book, unless otherwise indicated, all cash flows are to be considered as “expected” values rather than as contractual—or even certain—values. Likewise, the underlying after-inflation, or real, discount factors are deemed to be reflective of such economic uncertainty and therefore higher than what we would expect in TIPS.
We are still some way off from the valuation of actual individual equities and market composites. Most notably, complications associated with debt leveraging, net share issuance, income taxes, and others will be introduced in subsequent chapters. Here we master the basic theoretical and practical analysis, the understanding of which will permit us to deal with complexities in the rough and tumble of day-to-day equity investing.
The basic idea follows in the vein of the Leibowitz “franchise value” model ...
