How to Value Stocks : Part-1

How to value stocks? This is an ever intriguing question and thousands of books have been written on this. I plan to share my approach, a 80/20 approach in a series explaining at least 3 main methods with some formulae and examples. It is as complex as one wants to make and as simple I want to keep it by looking at big picture.

Disclaimer: It’s in no way to say these are absolutely correct methods. There are better metods available and if you would like to understand more, pls either find a “best seller from Aamzon or neighborhood store or Join a short 6months course. My approach is “80 for 20” and I therefore shall suggest to do your own due dilligence before diving into any transactions.

Dividend Growth Model (DGM)

Sometimes things are not complicated as we think or as it appears. Financial intelligence says, that the value of a stock is worth all of the future cash flows expected to be generated by the firm, discounted by an appropriate risk-adjusted rate.

Dividend Growth Model (DGM) is one of the way to value “Mature” and “Stable” companies. Companies like DOW 30 component stocks, an example will be CocaCola (KO). This model assumes has two basic assumptions- 1) Company has achieved its stable growth stage and now is growing at much more predictable pace and 2) The dividends has been distributed for long enough to assume it will continue to be distributed.

Let’s say, last dividend was D0 and current price is P0. g is the growth rate and Rr is the required rate of return. The Formula states:

P0=(D0(1+g))/(Rr-g), this formula is dervived using “Perpetuity” and “Time Value money concepts)

Let’s take a real-life example-

1. Coca Cola, Last 12 months Dividend D0 = $1.36
2. Dividend growth (over last decade) g= 9.23% (Check out the data for past 10 years and run either a regression analysis or a simple “rate’ formula using quarterly dividend as $0.14 in 1997 and $0.34 now)
3. Required rate of return Rr = 11.69% (=5.3%+0.83*(13%-5.3%))
4. Intrinsic Value of KO = $55.10 (=1.36*(1+9%)/(11.69%-9%)
5. Current Price of KO =$51, so it is slightly undervalued.

(Rr=Rf (aka Risk free Rate)+b(aka beta)*Equity Risk Premium (aka Market returns- Rf). Markets returns been roughly 11-13%% per annum. Risk free rate is long term treasury bond rate i.e. 5%-5.3%. KO beta is 0.83 (as per Yahoo finance).

Watchouts– Stock price has a positive relationship with the dividends (D) and the growth rate(g), and a negative relationship with the required rate of return (Rr). Simply put, required rate of return is the factor that more directly influences the stock price. And that’s where people have different opinions. For Mr Warren Buffet, he defines risk as “either there is risk or there is no risk, there is no such thing like beta”. (this is my version of discussion with him during our visit to him). To him, required rate of retrun is Rf as he thinks he will invest only if there is no risk and then value a company accordingly whether or not it is under valued or overvalued.

Conclusion: The dividend growth model is by no means a “final” valuation model. It forces investors to evaluate different assumptions about growth and future prospects. If nothing else, the DGM suggests the underlying principle that a company is worth the sum of its discounted future cash flows. The challenge is to make the model as applicable to reality as possible, which means using the most reliable assumptions possible.

But hey, we just need 80/20 idea to assess roughly if it’s overvalued or undervalued. We can always do more complex modelin later on. The key point here is, do your homework when you are planning to be “long” and DGM is a great start. Once you start doing it, it won’t take more than 10minutes.