How to find Intrinsic Value of Stocks

Valuing Share of a Company

Valuing stocks is the process of determining the current worth of a company’s shares. It involves analyzing a variety of financial metrics, such as earnings, revenue, and assets, to determine whether a stock is undervalued or overvalued. This information is used by investors to make informed decisions about whether to buy, hold, or sell a particular stock.

For stock valuation, analysts use the following five most commonly used models containing the formula for stock valuation.

1.  Discounted Dividend Valuation
2. Free Cash Flow Valuation
3. Market-Based Valuation: Price and Enterprise Value Multiples
4. Residual Income Valuation
5.  Private Company Valuation

Discounted Dividend Valuation

Cash flows are defined as dividends in the dividend discount model. The primary rationale for utilizing this definition of cash flow is that an investor who buys and keeps a share of stock typically receives only dividends in the form of cash returns. In practice, analysts typically believe that earnings influence investment value. Is it true that the concept of cash flow as dividends excludes earnings that are not delivered to shareholders as dividends? Earnings reinvested should create the foundation for future dividend increases. As a result, the DDM accounts for reinvested earnings when calculating all future dividends. Dividends are less volatile than earnings and other return ideas, hence DDM values may be less vulnerable to short-run variations in underlying value than alternative DCF models. Analysts frequently believe that DDM values indicate long-run intrinsic value.

Dividends are either paid or not paid by a stock. If a corporation is not profitable and has no funds to distribute, it may not pay dividends on its stock. In addition, a corporation may not pay dividends for the opposite reason: it is extremely profitable. For example, a corporation may reinvest all earnings rather than paying dividends in order to capitalize on profitable growth prospects. Dividends may be initiated as the company matures and faces less appealing investment prospects. In general, mature, profitable corporations tend to pay dividends and are hesitant to lower payout levels.

When DDM should be used

In general, the DDM and the concept of returns as dividends are most appropriate when:  the corporation pays dividends (i.e., the analyst has a dividend
record to analyze). the board of directors has set a dividend policy with a clear and consistent relationship to the company’s profitability; and the investor has a noncontrol perspective.

By answering the questions, an analyst has final responsibility in the selection of valuation models:

State whether a dividend discount model is an appropriate choice for valuing Co, A. Also, state whether a dividend discount model is a good fit for valuing Co, B.

The data in the following display is from the last 15 years. (In the table, EPS stands for earnings per share, DPS stands for dividends per share, and the payout ratio equals DPS divided by EPS.)

Interpretation

A DDM does not appear to be a viable alternative for valuing CO, A based only on the data shown in Exhibit. Since 1998, CO, A’s dividends have been $1.00 per share. CO, A’s EPS was $1.75 in 1998 but dropped dramatically to $0.37 in 1999. EPS recovered to $2.56 in 2002, but has since ranged from $1.77 to $3.94, with a 2012 value of $3.08. In short, from 2002 to 2012, CO, A grew at a compound annual rate of 1.9 percent with significant variability, whereas DPS remained unchanged. On the basis of the data supplied, it is difficult to detect an understandable and consistent relationship between dividends and earnings. Because dividends do not appear to alter to reflect changes in profitability, applying a DDM to CO, A is most likely incorrect. It appears that valuing CO, A on another basis, such as a company-level definition of cash flows, is more acceptable.

With the exception of 2003 and 2008, CO, B’s historical earnings indicate a long-term rising trend. Although you should look at such differing payout percentages, CO, B’s dividends have consistently tracked its profits growth. During the entire time, earnings per share and dividends per share climbed at comparable compound annual growth rates of 11.4 percent and 9.9 percent, respectively. EPS and DPS grew at comparable rates over the last four years, indicating a dividend payment ratio ranging from 28 percent to 32 percent. To summarize, given CO, B pays dividends and dividends have a clear and consistent link with profits, employing a DDM to evaluate CO, B is appropriate.

Combining the general DCF model with Gordon growth model

The first two-stage DDM provides for a high initial growth rate, followed by a sustainable and typically reduced growth rate thereafter. The multiple-period model underpins the two-stage DDM.

This is a PV of the high growth period (1)

The PV of the constant growth period (2)

Where Vn is the Gordon growth model to find Vn, such as by evaluating Vn, we combine it, general growth model, to obtain a two-stage DDM (3)

Two-Stage Dividend Discount Model (4)

Multistage Dividend Discount Models

The DDM’s fundamental phrase is too broad for investment analysts to utilize in practice since they can only anticipate a limited number of payouts individually. The most powerful simplifying assumption—a constant dividend growth rate indefinitely, resulting in the Gordon growth model—is unrealistic for many, if not most, businesses. Many public businesses’ growth is divided into three stages, according to experts.

1)   The initial stage of development. A firm in its growth stage usually has quickly growing markets, strong profit margins, and an exceptionally high earnings per share growth rate (supernormal growth). Because the firm invests substantially in growing activities, companies in this phase frequently have the negative free cash flow to equity. Because of the large potential returns on stock, growth-phase firms’ dividend payout ratios are frequently low, if not non-existent. Earnings growth rates inevitably fall as the company’s markets mature or as unexpected growth prospects attract competition.

2)   Transition phase. Earnings growth slows during this phase, which is a transition to maturity, as competition puts pressure on pricing and profit margins, or as sales growth slows due to market saturation. Earnings growth rates may be above average during this period, but they will eventually fall in line with the general economy’s growth rate. In this period, capital requirements usually decrease, leading to positive free cash flow and higher dividend payment ratios (or the initiation of dividends).

3)    Mature phase. When a firm approaches maturity, it reaches a point when investment possibilities yield its opportunity cost of capital on average. Earnings growth, the dividend payout ratio, and return on equity all approach the necessary return on equity, and earnings growth, dividend payout ratio, and return on equity all stabilize at levels that can be sustained over time. This phase’s dividend and profits growth rate is referred to as the mature growth rate. This period, in reality, corresponds to the point at which a firm may be correctly evaluated using the Gordon growth model, which is one method for evaluating a present high-growth company’s future.

Two-Stage Dividend Discount Model

There are two popular variants of the two-stage DDM. In Stage 2, both models assume continual growth at a mature growth rate (for example, 7%). Stage 1 reflects a time of extraordinary growth in the first version (“the basic two-stage model”), for example, growth of 15%. In most cases, the shift to mature growth in Stage 2 is sudden.

The H-Mode

During Stage 1, the dividend growth rate is anticipated to fall from an abnormal rate to the mature growth rate in the second version, known as the H-model. For example, the growth rate may start at 15% and gradually decrease in Stage 1 until it reaches 7%. After the overall two-stage model, the second model will be given.

A smoother transition to the mature phase growth rate might be more realistic in some situations. Fuller and Hsia (1984) created a two-stage model in which growth starts off fast and then slows down linearly over the supernormal growth period until it achieves a normal rate at the conclusion. In the H-model, the dividend stream has a value of (5) OR (6)

All else being equal, the greater the share value, the longer the supernormal growth period (i.e., the larger the value of H, which is one-half the duration of the supernormal growth period) and the larger the additional growth rate in the supernormal growth period (measured by g_S minus g_L).

Summary

Dividends, free cash flow, and residual income are some of the various streams of projected cash flows that may be utilized to assess shares. A discounted dividend method is best suited for dividend-paying companies where the firm has a clear payout policy with a clear link to profitability and the investor has a noncontrol (minority ownership) perspective. A minority interest, also known as a non-controlling interest, is an ownership position in which a shareholder holds less than 50% of the outstanding shares of a company. As a result, minority interest shareholders have no direct influence over company decisions or votes.

The value of any asset in a DCF model is the present value of its (anticipated) future cash flows. (8)

where V0 represents the asset’s value at time t = 0 (today), CFt represents the (anticipated) cash flow at time t, and r represents the discount rate or necessary rate of return. For assets with an unlimited lifespan, such as common stocks, n is limitless.

With a single holding term, the DDM calculates stock value as follows: (9) 

D_t = D_t–1(1 + g) in the Gordon growth model posits that dividends rise at a constant rate g indefinitely. In the Gordon growth model, the dividend stream has a value of (10)

Different growth rates are used in Stage 1 and Stage 2 of the two-stage dividend discount model. (11) 

The H-model posits that during Stage 1, the dividend growth rate falls linearly from a high supernormal rate to a normal rate, and then rises at a steady normal rate thereafter: (12)

Two basic three-stage models exist. The growth rate in the middle stage is constant in one variation. The growth rate in the second variant decreases linearly in Stage 2 before becoming steady and normal in Stage 3.

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