Stock Valuation: An Overview

The goal of stock valuation is to assess whether a stock is overvalued, undervalued, or fairly priced in the market. Stock valuation estimates the intrinsic value of a company or stock, and there are several ways to go about it. Here, we look at several of the main methods.

Stock Valuation: The Basics

The theory behind most stock valuation methods is that the value of a business is equal to the sum value of all future free cash flows in the company’s lifetime.  Since money in the future is worth less than money now, future free cash flows must be discounted at an appropriate rate to factor it in the value.

If you objectively know all future cash flows of a company, and you have a target rate of return on your money,  you can know the exact amount of money you should pay for that company.

Like anything else, if you have the accurate and sure inputs, the outputs you get from them are factual. If we knew exactly how much cash flow will generated, and we have a target rate of return, we can know exactly what to pay for a dividend stock or any company with positive free cash flows regardless of whether it pays a dividend or not.

Sadly, stock valuation is not that easy in practice, because we can only estimate future free cash flows. Since the inputs themselves are only estimates,  a degree of skill and experience is needed to come up with an accurate valuation. Hence, stock valuation is art and science.

To deal with that, it’s best to estimate conservatively and include a margin of safety.

Read how I use valuation methods in my stock buying process.

Example of Stock Valuation

If someone offered you a machine that was guaranteed to (legally) give you $10 per year, and the machine had zero maintenance costs, what would be a sensible amount of money to pay for this machine? It would depends on a few factors.

1) The $10 represents owner’s profit, or free cash flows. This is money you get free and clear.

2) Due to the time value of money, $10 next year is not as valuable to you as $10 this year. Why? Because you could take $10 this year, invest it, and probably turn it into $10.50 or $11 by next year.

This second point highlights the purpose of discounting. You have to discount the future money by an appropriate value to translate it into today’s value. How much you discount it by can vary. You could, for example, use a “risk-free” rate of return, such as the yield on a U.S. Government Treasury Bill. Or, you could use Weighted Average Cost of Capital (WACC). More appropriately, and simply, in my view, what to use is your targeted rate of return.

If you want to get, say, a 10% rate of return on your money, use a discount rate of 10%. You may adjust it according to your estimate of the level of risk involved. For a higher risk investment I’d use a higher discount rate (perhaps 12% or so), while in very defensive and reliable business I might use a discount rate of a bit under 10%. A famous quote by Buffett is that you can’t compensate for risk with a high discount rate, and that’s true in my view. I don’t recommend using particularly high discount rates.

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Discounting Future Returns

How much is $10 next year worth to you today if you seek a 10% rate of return on your money? The answer is $9.09. If you had $9.09 right now, and you could invest that money at an annual rate of 10%, then you could turn that $9.09 into $10 in one year, since $9.09 multiplied by 1.1 equals $10. So $10 one year from now is only worth $9.09 to you today.

I calculated that via this equation:

DPV = FV / (1 + r), where:

• DPV means “discounted present value”
• FV means “future value”
• r is my discount rate, or desired rate of return (which in this case is 10% or 0.1)

The $10 is future value, and I want to know the discounted present value of that $10, so I divide it by 1.1 (1 + 0.1) to get the DPV, which is the present day value of that money.

If you want to know what $10 that you’ll receive in two years is worth today, you make a minor adjustment to that equation, and use DPV = FV / (1 + r)^2, because the discount rate must be applied for two years. The answer is that receiving $10 two years from now is worth $8.26 to you today; if you take $8.26 and multiply it by 1.1, and then multiply it by 1.1 again, you get $10.

So we know that, for a given future value, the discounted present value is

DPV = FV / (1 + r)^n

For the sum of annual future cash flows, the equation is this:

DPV = (FV1)/(1+r) + (FV2)/(1+r)^2 + … + (FVn)/(1+r)^n

These are some well-known stock valuation equations.

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Valuation of the Machine

Going back to the example, how much is the machine worth to you if it’s guaranteed to give you $10 per year, forever, and you want a 10% rate of return on your current money?

• The $10 it gives you in one year, is worth $9.09 today.
• The $10 it gives you in two years, is worth $8.26 today.
• The $10 it gives you in three years, is worth $7.51 today.

The farther we go in the future, the less that $10 is worth to you today, since it would take a smaller sum for you to compound to that $10 over longer periods.

The machine’s value is equal in value to all of its discounted future cash flows, a key aspect of stock valuation. In one year, it produces $10, which is worth $9.09 to you today. A year after that, it produces another $10, which is only worth $8.26 to you today. And so forth. If the machine operates forever, it technically produces an infinite amount of cash, but it’s certainly not worth paying an infinite amount of money for, since you want a good rate of return on your current money.

Summing up Future Cash Flows

If you sum up the next 25 years of discounted cash flows from this machine ($9.09 + $8.26 + $7.51…for 25 years), you get a value of $90.77. (The 25th year of $10 is only worth $0.92 to you today; the discounting makes the cash flows rather negligible over time).

Summing up the next 50 years of discounted cash flows from the machine reaches a value of $99.22. And for the next 75 years, you get a value of $99.92.

At this point, you should see that the answer is approaching $100, like a limit in calculus. A few decades was sufficient to show this.

If you want a 10% of return, and it can be proven that the machine works like it says it will, and that it will produce $10 per year forever with no maintenance costs, then it’s objective to say the machine is  worth $100 to you. Buying it at that price would be appropriate, and you would meet your target rate of return. If you can buy the same machine for less than $100, even better! If it only sells for more than $100, you either have to reduce your expected rate of return on your money, or invest elsewhere.

Building a Portfolio of Machines

Suppose you made it a hobby of buying such machines. Some machines produce $20 every year, others  $100 every year. Some produce $10 the first year, then $11, then $12, and so on. Others have shrinking returns, perhaps $50 the first year, then $49, then $48, and so on. You could find people who are selling them, and inspect them to make sure they are legitimate and in good condition.

Then you could perform discounted cash flow analysis with a target rate of return in mind. You would buy the machines you can get for at your calculated fair price or less, essentially building yourself a portfolio of machines. You’d calculate the fair price of each one by summing up all future cash flows, and discounting them based on your target return. Each machine is worth a sum equal to the sum of all future discounted cash flows. The same is true for stocks.

It doesn’t matter whether the machine produces the same amount each year,  a growing amount, or even a shrinking amount. You can add up all future cash flows, discount them to the current value of that money, sum those discounted cash flows up, and buy for an amount equal to or under that price. Of course, any growth in cash flows, or lack thereof,  affects the value of the discounted cash flows and therefore the total value of the investment itself.

Adding in Some Safety

Let’s complicate things a bit, and say that a machine produces $10 in profits each year, but requires $1 in maintenance each year. In that case, only $9 is “free cash flow”, and that’s the number we’d have to use in our calculations. We could apply this powerful equation of discounted cash flow to all sorts of machines, and make good money.

What if 1 in 20 of the machines breaks? You might not get the return you wanted. To ensure you still get your 10% rate of return, you’ll need to buy most of your machines at a slight discount, so that when machine breaks occasionally, you’ll still do well overall with a diversified portfolio of machines. That’s the concept of a margin of safety, and that’s how we build a collection of the best dividend stocks.

Three Primary Stock Valuation Methods

Many valuation metrics are readily calculated, such as the price-to-earnings ratio, or price-to-sales, or price-to-book. But these are numbers that only hold value with respect to some other form of stock valuation.

The three primary stock valuation methods for evaluating a healthy dividend stock are:

Discounted Cash Flow Analysis

The first method, Discounted Cash Flow Analysis, treats the company as one big free cash flow machine. We analyze the company as though we would buy the whole thing and hold it indefinitely for all of its future free cash flows. If we estimate the value of a company, we can compare it to the current market capitalization of that company to determine whether it’s worth buying or not. Alternatively, we can divide the total calculated value by the total number of shares, and compare this value to the current price of the shares.

Dividend Discount Model

The second method, the Dividend Discount Model (DDM), treats an individual share as one little free cash flow machine. The dividends are the free cash flow, since that’s the cash that we investors get. A company could spend free cash flows on dividends, share repurchases, acquisitions, or just let it build up on the balance sheet, and we have little control over what management decides to do with it. The dividend, however, takes all of this into account, because the current dividend and the estimated growth of that dividend, takes into account the free cash flows and how management uses them.

The DDM only works well for companies paying a dividend yield of 3% or more. For companies with lower yields, use another valuation method.

Earnings Multiple Approach

The third method, sometimes called the Earnings Multiple Approach and based on the P/E ratio, can be used whether the company pays a dividend or not. The investor estimates future earnings over a period of time, such as ten years, and then places hypothetical earnings multiple on the final estimated EPS value. Then, cumulative dividends are taken into account, and the difference between the current stock price, and the total hypothetical value at the end of the time period, are compared to calculate the expected rate of return.

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