Assigning Value to Brains and Brands

Of several hundred RealMoney columns I've written over the past few years, perhaps the one that generated the most email was on bond fund manager Bill Gross' call for Dow 5000. That piece brought in tons of passionate responses, many of which were longer than the column itself!

I saved one of those emails, written Sept. 12, 2002, by RealMoney reader J.L. It's interesting to review this note now, some 14 months later. While the Dow hasn't come close to 5000 in the past year, this email still has several points that are worthy of comment:

"Arne, I don't think the ultimate point in Bill Gross' Dow 5000 article was dividend yields, but valuation. The American stock market is still absurdly expensive."

I think that thesis is mistaken on both counts. Gross came up with a Dow 5000 target based on the dividend yield, a metric that has nothing to do with the valuation of a business. I put myself in the position of a control investor when I do my valuation work. That doesn't mean I value the company as if I owned 100% of the stock, but as if I owned sufficient shares to "control" the corporation. For example, Ralph Lauren owns more than 40% of the shares of Polo Ralph Lauren (RL - commentary - Cramer's Take). That's enough to put him in a control position. By the way, Lauren also owns almost all of the voting shares -- similar to Phil Knight of Nike (NKE - commentary - Cramer's Take).

Determining Value

To control investors, dividends are irrelevant to valuation. What does determine value then? It's all about earnings, cash flow (especially free cash flow) and net assets (net of all liabilities, including contingent and off balance sheet liabilities).

Whether a control investor decides to pay out all of the earnings in dividends or pay no dividends at all has nothing to do with the value of the business. So it is with using the dividend yield as a metric to value the Dow Jones Industrial Average: It's irrelevant. To say that, based on historical dividend-yield norms, the Dow would have to fall to 5000 tells me nothing about the earnings, cash flow and net assets of the 30 companies that make up the Dow average. Clearly, many significant companies with very valuable assets pay no dividend at all, such as Berkshire Hathaway (BRK.A - commentary - Cramer's Take).

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Arne Alsin is the founder and principal of Alsin Capital Management, an Oregon-based investment advisor and portfolio manager of The Turnaround Fund, a no-load mutual fund. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. At time of publication, Alsin and/or ACM had no positions in any of the securities mentioned, although holdings can change at any time. Alsin appreciates your feedback and invites you to send it to [e-mail]. Click here to receive Arne's latest favorite stock picks from his newsletter, TheStreet.com Value Investor.