Stock Valuation Models: Types & Overview

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  • 0:04 Stock Valuation
  • 0:38 Dividend Growth Model (DGM)
  • 2:02 Discounted Cash Flow…
  • 3:56 Comparable Company…
  • 5:08 Lesson Summary
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Lesson Transcript
Instructor: Juliana Barnes

Juliana has an MA in Literature.

This lesson takes a look at the three most popular types of stock valuation models. If you ever wondered why one stock is priced at $100 and another at $1,000, this lesson will help explain why.

Stock Valuation

After Fred and his wife sold their house and needed a place to put their extra income, he discovered the stock market. But something always bothered him. What are these stocks really worth? While there are many issues that can affect a stock price, what are stocks worth on their own merits without all of the noise from politicians and macro forces like pandemics? That is what we'll explore in this lesson. After all, Fred has his kids' education as well as his and his wife's retirement to cover. Let's look at a few popular stock valuation models.

Dividend Growth Model (DGM)

One of the easiest models to use is the dividend growth model. It assumes that a stock is worth the money it will pay out to shareholders in the future, which are dividends. To use the model, we need:

  • the current year's dividend (Do)
  • the growth rate of the dividends (g)

We will discount this amount to its present value to get the value of the stock today using the discount rate (r). Fred uses a rate of 10%. The stock Fred is looking at today is Big Green Corp. It pays a dividend of $4.95 per share and it's expected to grow by 5% per year. We can find next year's dividend (D1) by taking this year's dividend (Do) and multiplying by 1 plus 5%.

D1 = Do (1 + g)

D1 = $4.95 (1.05)

D1 = $5.20

Once Fred has that figure, he can use the full formula to find what the stock is worth.

Stock Price = D1 / (r - g)

$5.20 / (0.10 - 0.05)

Stock Price = $104

This is useful because if the price is less than $104, the stock may be undervalued, making it one Fred may want to consider investing in.

Discounted Cash Flow (DCF) Model

The discounted cash flow model is used to value any asset. It assumes that a company is worth the free cash flow (FCF) it will generate for its owners. The DCF model discounts each yearly cash flow by the discount rate to get the present value today. It works for stocks too, but it can be difficult to forecast future cash flows. Fred finds some estimated cash flows from industry experts and we will use them in a simple model.

A small company will generate these three cash flows per share (FCF / number of shares outstanding) for the next three years.

Year FCF per Share
1 $50
2 $60
3 $70

The formula for the discounted cash flow model is:

DCF = (FCF1 / (1 + r)) + (FCF2 / (1+r)2) + (FCF3 / (1+r)3)

Where FCF1, 2 and 3 are the three FCF amounts in the table.

The discount rate we'll use is still 10%, so the calculation for discounting the free cash flows is:

($50 / 1.10) + ($60 / 1.102) + ($70 / 1.103) = $147

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