Stock Valuation Models: Part 2
In part 1 of this guide to stock valuation models for the Discounted Cash Flow (DCF) methodology, you have learned how to estimate the future cash flows of the company by considering the forecast period and its terminal value.
Part 2 is a continuation of the DCF model, where we delve into the final two steps needed to complete the analysis. Moreover, there will be an introduction of a simpler version of stock valuation known as the Dividend Discount Model or DDM for short
Key Stock Valuation Model: Discounted Cash Flow (DCF)
Step 2: Choose a Discount Rate, r
Once you have determined a good estimation of the company’s cash flows for the next few years (Step 1), and an appropriate terminal value (Step 1.5), the next step is to pick a discount rate. The discount rate is typically represented by the cost of capital, such as the interest rate. It needs to reflect the “riskiness” of an investment.
For business valuation purposes, a firm’s Weighted Average Cost of Capital (WACC) is commonly used as a discount rate. This information can usually be obtained online.
WACC accounts for the firm’s financing costs of equity and debt and is considered to represent the opportunity cost of funds used. It represents the rate of return that investors expect from investing in the company.
Weighted Average Cost Of Capital (WACC)
When the WACC of a company cannot be found online, we have to derive it manually using a formula.
Understanding Weighted Average Cost Of Capital
WACC can be a confusing concept to understand. If you are not interested in getting into the details, you can skip to the formula below.
The formal definition of WACC is the required rate of return for the entire business for the risks investors bear when they invest in the company.
On the other hand, the layman’s definition of WACC is the discount rate used to discount projected Free Cash Flows in a DCF model, as stated above.
These definitions are the same. If an investor requires a specific return on his investment dollars today, then future cash flows from an investment he makes can be converted into today’s dollars using that required rate of return.
This is the present value for future cash flows. The WACC does this for all investors in a company, weighted by their relative size. How then do we determine what that required rate of return should be?
This discount rate should be a function of the best alternative investment opportunities available to the investors, and the riskiness of making that investment in the company relative to those available alternative returns.
For example, if the risk-equivalent return in other opportunities is 10% per year, then an investor should require a 10% return from this investment as well. And so to determine the present value of the investment, we need to discount all future benefits (cash flows) by 10%.
This is the formula of WACC:
E = Value of Equity or market cap of the company
D = Value of Debt or total amount of debt on its balance sheet
re = Cost of Equity, found using the CAPM model (more on that later)
rd = Cost of Debt, weighted average cost of interest payment on debt obligations
t = corporate tax rate
Most of the data in the WACC formula can be easily sourced with the exception of re which is the Cost of Equity. One way of calculating its value is through the Capital Asset Pricing Model or CAPM model for short. re considers the risk you are taking on and how much you could make elsewhere.
Formula for CAPM
The yields of super-safe 10-year US government bonds are typically used as the risk-free rate of return, Krf. The historical market risk premium (RP) is how much extra the stock market overall tends to deliver above that risk-free-rate. Using a long term average, that risk premium is typically around 6.5%
Beta (b) measures the volatility of the stock you are valuing – its a proxy for how risky it is compared to the wider market, helping you figure out what your compensation should be for taking on the risk of that particular stock. For example, a tech stock like Tesla will have a Beta that is significantly more than 1.0 (more volatile than the broader market) while a consumer staple stock such as Walmart will have a Beta that is less than 1.0 (less volatile than the market).
Calculation of WACC
Assuming you have the following Beta of market risk premium information of a stock: Beta = 1.035 (slightly more volatile than market) and RP = 8.0%. Your WACC calculation is illustrated below
In this case, our discount rate would be 0.105 or 10.5%
Step 3: Calculate the DCF
To recap, in Step 1, we estimate the CF of the company and its associated Terminal value.
In Step 2, we calculated the WACC or the discount rate of the counter.
Step 3 is essentially to apply the formula as shown above, adding the discounted value of each future cash flow to the company’s discounted terminal value. This final step can typically be calculated with the help of an Excel sheet
After these 3 steps, there is one final step that determines whether you should invest – compare your result with the current share price of the investment.
The true value of a share of the stock can be roughly estimated by dividing the sum of all the future cash flows (discounted to the present year) by the total number of shares issued.
If the DCF shows that the true value is above the current price of the investment, the investment may be worthy as the intrinsic value is greater than the market value; if the opposite is true, the investment will likely yield negative returns as the real value is lower than the market value.
Sources Of DCF Information
The following platforms can help provide the required information in your DCF analysis:
- Historical Financial Results:
The SEC (http://www.sec.gov/) has company Annual Reports (10-K), Quarterly Reports (10-Q), and Investment Prospectuses (where available).
- Cost of Debt:
This information is almost always available for each debt instrument in a company’s Annual Reports (10-K) and Quarterly Reports (10-Q).
What You Need To Know About Discounted Cash Flow
An interesting thing to note about the DCF valuation model is that almost all of its components are made up of assumptions or estimations.
For one, an investor would have to forecast the future cash flows from an investment. This is not an easy feat. Future cash flows are dependent on a mixture of complications, such as market sentiment, the state of the economy, technology, competition, and unforeseen threats or opportunities.
Estimate future cash flows to be too high, and risk making an investment that might not pay off in the future. But estimate cash flows to be too low, and risk missing good opportunities.
Picking a discount rate for the model is also an assumption, one that makes a huge impact on the overall decision. A 1% uncertainty may mean the difference between buying or selling.
That being said, this does not render the DCF model incorrect or unreliable – the best physicists frequently use estimations and assumptions even in the context of cold hard science. As successful investors from Keynes to Buffett and Munger have repeated often: “it is better to be approximately correct, as opposed to precisely wrong.”
It is difficult to find a universal DCF calculator or spreadsheet model that you can just plug values into. The heavy reliance on estimations and intuition is why the DCF model differentiates good stock analysts from mediocre ones.
Key Stock Valuation Model: Dividend Discount Model (DDM)
The dividend discount model (DDM) is based on a similar concept to the discounted cash flow (DCF) model but only applies to firms that have a history of stable dividend payouts.
The Underlying Principle of DDM
The DDM takes the same assumption as the DCF, which is that the intrinsic value of an investment is represented by the present value of all future cash flows of the company. At the same time, the company uses all of its free cash flow to pay dividends to the shareholders, so dividends are essentially the positive cash flows generated by a company at regular intervals.
Gordon Growth Model (GGM)
The most basic and popular version of the DDM is the Gordon growth model (GGM), named after American economist Myron J. Gordon.
The Gordon growth model (GGM) assumes a stable dividend growth rate over the years.
The formula of GGM is expressed in the following way:
Where:
P = the fair value of a stock
D1 = the estimated value of next year’s dividend
r = discount rate (usually calculated using CAPM)
g = the constant growth rate of the company’s dividends
Let’s break it down.
D1 is the estimated value of the following year’s dividends. This estimation can be done by looking at the firm’s historical dividends and any announcements to raise or cut their dividend payouts.
r is the discount rate or the investor’s required rate of return. This is usually calculated using the Capital Asset Pricing Model (CAPT). For most companies, this value can be obtained online via a simple search.
g represents the expected dividend growth rate. One way to calculate g is to multiply the return on equity by the retention rate (1 minus the dividend payout ratio). Another way is to simply observe the past dividend payout trends and estimate the average growth rate from there.
Example Of Gordon Growth Model
Imagine a company with a current stock price of $100. You predict it will pay a $1 dividend per share next year (D1), and this amount is expected to increase by 1% annually (g). An investor with a required rate of return of 5% (r) wants to know if they should buy the stock.
The intrinsic value (P) of the stock is calculated as follows:
According to the Gordon Growth Model, the shares are currently $75 overvalued in the market!
Drawbacks of the Gordon Growth Model
There are some limitations to the GGM:
Dividend Growth Rate Must Be Constant
The model assumes that the dividend growth rate is constant, which is not always an accurate reflection of real life. Constant dividend growth rates are more common among blue-chip companies in established industries. On the other hand, newer companies and industries are prone to fluctuating dividends due to the high risk of volatility as they develop.
Required Rate of Return Must Be Higher Than Growth Rate
The required rate of return/cost of equity (r) must be higher than the dividend growth rate (g). Otherwise, the math is invalid.
Conclusion: There is no simple answer
The diagram below is a simple flowchart in selecting your stock valuation models.
One can start off with the simple dividend discount model as the preferred stock valuation model if the company has a good track record of steady dividend payment.
Alternatively, one can deploy the discounted cash flow model which is slightly more tedious due to the various assumptions involved.
Last but not least, you can also deploy the P/B or P/B multiples methodology which is alot more simpler as a stock valuation method for new investors.
Equity research and valuation is one of the most nuanced topics in investing. At the end of the day, these models and formulas are just tools in your shed. It is now up to you to pick up these individual tools and build for yourself the house you envision.
There is no single ratio or number that will “magically” help you choose between buying or selling. Nevertheless, when wielded frequently and to their full extent, they can be powerful references for you in your investing journey.
Finally, you can see for yourself what Warren Buffett meant when he said the words:
I am fearful when others are greedy, and greedy when others are fearful.
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Disclosure: The accuracy of the material found in this article cannot be guaranteed. Past performance is not an assurance of future results. This article is not to be construed as a recommendation to Buy or Sell any shares or derivative products and is solely for reference only.
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