There are two ways to consider cashflows—dividends per share and earnings per share. First, let’s consider dividends with an example.
(This is an oversimplified example. In the real-world dividend payments are not this stable, and neither is interest rates. Shares are also riskier than bank accounts, so shares always must yield significantly more than a bank account. Furthermore, dividends are compared to bonds rather than bank accounts. However, these examples should illustrate the principle of using cash flows to value a share.)
Imagine you have $100 and you know for certain that you can earn 3% interest in a bank account and that the interest rate won’t change. So, you can put the money in a bank account and receive $3 every year until you withdraw your $100.
Now imagine a company’s shares are trading at $100 and you know for certain the company will pay a $3 dividend each year. In this case, owning one share would be exactly the same as depositing the money in a bank account. You would receive $3 every year and at any stage, you could sell the share for $100. It would continue to trade at $100 because it would always be equivalent to depositing money in the bank.
Now, let’s consider a company paying a dividend of $2.50. If the share price was $100 this would be a lower return than the bank account. But what if the share price was $80? The return would then be 2.5/75, or 3.33%. The share would then be more attractive than the bank account because it would yield more.
If the dividend was $6, then any share price up to $200 would give you a better return than the bank. If you could buy the share for $150 (assuming you have more than the original $100) you would be earning 6/150, or 4%.
This is how dividends can be used to determine a share price that yields a better return than a bank account. But in the real world, if a company can grow its profits, it can grow its dividend payout too.
Let’s imagine a company is going to pay a $1 dividend this year and after that, the dividend will increase by 25% each year. That means that by year 10, the dividend will be $7.45. In total, the company will pay out $33 in dividends over ten years, with an average yield of 3.33%. So, although the current dividend is just $1 compared to $3 from the bank, over ten years the share will yield more than the bank account. In addition, the share will be worth a lot more after ten years because it will be yielding $7.45. This is how equity investors earn increasing dividends while the share price also increases.