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.
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.
FCF per Share
The formula for the discounted cash flow model is:
Performing the calculations with pencil and paper can be difficult, but they can be made simpler by using Excel or a good calculator. Using Excel, the answer is $147. You can perform these calculations as far into the future as you wish, just keep adding one more year to the exponent for each year you add. This may be the best method to use, but estimating free cash flows can be difficult. However, wealthy investors still use this method, not only to determine a value for stocks, but also for sports franchises, companies, or any other project they may want to buy into.
Comparable Company Analysis (CCA)
A comparable company analysis (CCA) is based on the fact that companies that are similar will have similar financial ratios. Specifically, a relatively easy method is based on the price to earnings (P/E) ratio. The assumption is that stock prices will be based on some multiple earnings. If the stocks in a particular industry typically trade at 20 times earnings, its P/E ratio is 20. We can use that information to determine the price of all of the company's stocks. The formula is:
So, if a company made $7 per share and the earnings multiple is 20, then:
20 = Stock Price / 7
Stock Price = $140
Another method involving ratios uses earnings before taxes, depreciation, and amortization (EBITA). It claims that businesses in the same industry will have similar values for their enterprise value over the EBITA. An advantage of these methods is that the information needed is available on websites that are free to the public.
In this lesson, we covered the three most popular types of stock valuation models:
Dividend growth models (DGM) are based on the idea that a stock is worth the money it will return to investors in the form of dividends.
Discounted cash flow models (DCF) value a stock or any asset based on the free cash flow it will make available to investors or common shareholders.
Comparable company analysis (CCA) are based on the idea that firms of similar size in the same industry will have roughly equivalent ratios regarding earnings and stock prices.
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