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 earned later is worth less than money earned 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. Therefore, stock valuation is art and science.
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:
Earnings Multiple Approach
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The first method is the quickest to use and you will read about it everywhere as it stands with a single number. Sometimes called an Earnings Multiple Approach, it 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.
I think it’s a great starting point but you can’t use this value alone. I prefer looking at the company’s 10 year P/E ratio evolution. This gives me a better idea of how the market values the business. After all, it doesn’t really matter how I value it if the whole market is against me. You want to make sure you can sell the stock at a higher price at one point.
Discounted Cash Flow
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The second 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.
This requires more data digging and is followed by more assumptions from investors. It is sometimes hard to determine at which pace a company will increase its cash flow. However, you can also use this model to assess any type of companies, not only dividend stocks.
Dividend Discount Model
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The third 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.
The Dividend Toolkit
I know that stock valuation is often seen as being complicated and requiring lots of work. It requires lots of hard calculation and you may sometimes feel loss in the process. But there is a tool that can help you.
Back in March 2015, I bought another blog; The Dividend Monk. The reason why we made this move was to extend our readership and provide a more “hard-data-calculation” approach to our investors. In fact, through our acquisition, we also bought full copyrights of the Dividend Toolkit . This is a complete book about dividend investing and stock valuation. But most importantly, it provides you with an excel spreadsheet to quickly use both Discounted Cash Flow and Dividend Discount model. The book explains exactly how to use the spreadsheet and I’m sure it will make your calculation easier.
You can buy it for $19.95 by clicking on the image below. This is a .zip file including a pdf book of 200+ pages and the excel spreadsheet:Google+