Question

What are three methods for valuing common stocks, and when does each apply?

Answer 1

Following three rare the most common methods for valuing common stocks-

1. Dividend Discount Model (DDM):

The Dividend Discount model assumes that company pays regular dividend at zero growth rate, constant dividend growth rate or uneven dividend growth rate for forever therefore intrinsic value of share can be determined by discounting all the future cash flows (dividends) to the present value. Required rate of return are used as a discount rate for present value calculation.

Formula to calculate the current share price by dividend discount model for zero dividend growth rate

Stock Price P = D / k

And formula to calculate the current share price by dividend discount model for constant dividend growth rate

Stock Price P = D1 / (k – g)

Where:

P = the current stock price

D1 = dividend for next year

k = required rate of return

g = growth rate of dividends

For uneven dividend growth rate, multi stage dividend growth model are used to calculate the share price. This method is used for dividend paying stocks.

2. Discounted Cash Flow Model (DCF):

Discounted Cash Flow valuation is based on projections of free free cash flow of a the company for some forecasting period and terminal value calculation after that forecasting period then discounting them to the present value by using appropriate discount rate. The stock price is calculated by dividing the value of equity by number of shares outstanding. The Discounted Cash Flow Method applies to the companies with stable, positive and predictable free cash flows.

3. Comparable Method (Ratio analysis):

The stocks that do not pay dividends or have irregular dividend, the valuation of such stocks can be done by using the price-earnings (PE) ratio, the price to sales ratio or price to cash flow ratio etc. This method compares the stock’s price multiple to industry average or other benchmarks to know that the stock is comparatively undervalued or overvalued. This method can be applied mostly in all conditions as there are different numbers of multiples that can be used in different situations.