This is the third in a series of articles elaborating on The Dividend Observer Investment Process.
The theory behind most of the stock valuation methods is that, the value of a business is equal to the sum value of all future free cash flows. All future cash flows are discounted due to the time value of money. Nobody knows exactly how much cash flow will be generated in the future. Therefore, we will conservatively estimate the future cash flow and provide ourselves with a margin of safety (just in case our estimates fail). Stock Valuation requires some degree of skill and experience to be accurate.
There are so many stock valuation methods out there but I will discuss here only the two stock valuation methods that I use primarily in evaluating a healthy dividend stock.
Discounted Cash Flow Analysis
Discounted Cash Flow Analysis (DCFA) is the first and maybe the most used (popular) valuation method. This method analyzes the company as if we will buy the whole thing and hold it indefinitely. If we estimate the value of a company then divide it with the total number of shares to get the price per share and compare this value to the current traded price of the share to determine whether it’s worth buying or not.
The discounted cash flow formula is derived from the future value formula for calculating the time value of money and compounding returns.
Or Future Value (FV) = DCF * (1+r) + DCF * (1+r)2 + … + DCF * (1+r)n
The Dividend Discount Model
The Dividend Discount Model (DDM) is a simple procedure for valuing the price of a stock. This procedure however doesn’t work for companies that don’t pay dividends. The Value of the stock is calculated as
If the calculated value of stock is higher than the current stock price, then we can say that the stock is undervalued.
The DDM is based on the exact same idea as that of DCF, except that we are valuing the share of stock using the future dividends instead of future cash flows.
The inputs that we require to obtain the value of the stocks using the two methods described above are: the cash flow, the last year amount of dividend, the dividend growth rate and the discount rate or your target rate of return. Simply plug in the input to the formula above and voila! You will have the stock value. It is just simple right?
Due to the simplicity of my valuation methods, as I said earlier, the calculated stock value of either method is just an estimate. In order to have a margin of safety, my purchase price will be 20% below the calculated value.
In the next post in the series (STEP 4), I am going to evaluate the stock using the technical analysis.