Stock Valuation: The Basics
Companies have an intrinsic value, and that intrinsic value is based on the amount of free cash flow they can provide during their effective lifetime. Money later is worth less than money now, however, so future free cash flows have to be discounted at an appropriate rate.
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. All future cash flows are discounted due to the time value of money. If you objectively know all future cash flows of a company, and you have a target rate of return on your money, then you can know the exact amount of money you should pay for that company.
But stock valuation is not that easy in practice, because we can only estimate future free cash flows. This valuation approach, therefore, is a blend of art and science. Given the inputs, the outputs are factual. If we knew exactly how much cash flow is to be 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. But the inputs themselves are only estimates, and require a degree of skill and experience to be accurate with. Hence, stock valuation is art and science.
To deal with that, we should estimate conservatively and provide ourselves with a margin of safety.
An 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 depend 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 and probably invest it and turn it into $10.50 or $11 by next year.
This second point brings up the purpose of discounting. You have to discount the future money by an appropriate value in order 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 you should usually use is your targeted rate of return.
If you want to get, say, a 10% rate of return on your money, then you should use a discount rate of 10%. You may also alter it depending on your estimation 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 may 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.
So how much is $10 a year from now, 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”, and FV means “future value”, and r is my discount rate (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 ten dollars, so I divide the FV by (1 + 0.1) to get the DPV of that money.
If you wanted to know what $10 that you’ll get in two years is worth today, you make a minor adjustment to that equation, and use DPV = FV / (1 + r)^2, since 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, since you can take $8.26 and multiply it by 1.1, and then multiply it by 1.1 again, to get $10.
So we see that DPV = FV / (1 + r)^n, for a given future value.
If we have a sum of annual future cash flows, then the equation is this:
DPV = (FV1)/(1+r) + (FV2)/(1+r)^2 + … + (FVn)/(1+r)^n
These are some of the well-known stock valuation equations.
Now, 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 desire a 10% rate of return on your current money?
When it gives you $10 in one year, this money has a present value of $9.09.
When it again gives you $10 in two years, this money has a present value of $8.26.
When it again gives you $10 in three years, this money has a present value of $7.51.
The farther in the future the same $10 is, the less it’s worth to you today, since it would take a smaller sum for you to compound to that amount.
The machine, therefore, is equal in value to all of its discounted future cash flows, which is 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.
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’ll calculate 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). If, instead, you sum up the next 50 years of discounted cash flows from this machine, you’ll calculate a value of $99.22. If, instead, you sum up the next 75 years of discounted free cash flows from this machine, you’ll calculate 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 us this.
If you desire a 10% rate of return, and it’s able to be proven that the machine works like it says it will, and will produce $10 per year forever with no maintenance costs, then it is an objective fact that this machine is worth $100 to you. If you were to buy it at that value, it would be appropriate, and you would meet your target rate of return. If you could buy the same machine for less than $100, even better! If those machines only sell for over $100, then you either need to reduce your expectations of rate of return on your money, or invest elsewhere. When it comes to stock valuation, investors unfortunately aren’t that patient.
Suppose you made a side hobby out of buying those machines. Some machines produce $20 every year. Some produce $100 every year. Some produce $10 the first year, and then $11, and then $12, and then $13, and so on. Some even shrink, so perhaps they produce $50 the first year, then $49, then $48, and so forth. You could go around, finding people who are selling them, and take the time to inspect them to make sure they are legitimate and in good condition. Then you could perform discounted cash flow analysis on them with a target rate of return in mind, and then buy the machines and build a portfolio of them if you can get them for at-or-under my calculated fair price. And you calculate the fair price by summing up all future cash flows, and then discounting them based on your targeted rate of return. Each machine is worth to you a sum equal to the sum of all future discounted cash flows. The same is true for stock valuation.
It doesn’t matter whether the machine produces the same amount each year, or produces 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 or lack thereof in the cash flows affects the value of the discounted cash flows and therefore the total value of the investment itself.
We could even get more complicated, 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.
Suppose, however, that 1 in 20 of those machines actually breaks. In order to make sure you still get your desired 10% rate of return, you’ll need to buy most of your machines at a mild discount, so that when the occasional machine breaks, you’ll still do well overall with a diversified portfolio of these 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, is to treat 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 what the market capitalization of that company currently is to determine whether it’s worth buying or not, or alternatively, we can divide the total calculated value by the total number of shares, and compare this value to the current real price of the shares.
The Dividend Discount Model
The second method, the Dividend Discount Model, is to treat an individual share as one little free cash flow machine. The dividends are the free cash flow, since that’s the cash that we as investors get. In the company-wide example, a company could spend free cash flows on dividends, share repurchases, acquisitions, or just let it build up on the balance sheet, and the point is, 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 as well as the estimated growth of that dividend takes into account the free cash flows of the company, and how management is using those free cash flows.
Earnings Multiple Approach
The third method, sometimes called an Earnings Multiple Approach, can be used whether or not the company pays a dividend. The investor estimates future earnings over a period of time, such as ten years, and then places a 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 in order to calculate the expected rate of return.
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