Question

Please explain the advantages and disadvantages of using the following stock valuation techniques:

1) Discounted Dividend Model

2) Method of multiples

3) Discounted Cash Flow Valuation

Answer 1

1) Discounted Dividend Model

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

Advantage: It is used for zero growth rate, constant dividend growth rate or uneven dividend growth rate for which multi stage dividend growth model are used to calculate the share price.

Disadvantage of using this stock valuation techniques is that it is used only for dividend paying stocks. The stocks which are not paying dividends, this method is not applicable.

2) Method of multiples (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.

Advantage: This method can be applied mostly in all conditions as there are different numbers of multiples that can be used in different situations.

Disadvantage of using this stock valuation techniques is that sometime it is difficult to find out identical comparable in the industry or peer group.

3) Discounted Cash Flow Valuation

Discounted Cash Flow valuation is based on projections of free cash flow of a the company for some forecasting period and terminal value calculation after that forecasting period, then discounting it 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.

Advantage: Intrinsic value of equity is calculated by this method and it applies to the companies with stable, positive and predictable free cash flows.

Disadvantage of using this stock valuation techniques is that it is used only for the companies with positive free cash flow. If the free cash flow is not stable, positive and predictable, this method is not applicable.