Three Primary Stock Valuation Methods
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:
The first 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.
The Dividend Discount Model
The second 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 second 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.
Earnings Multiple Approach
The third method, sometimes called an Earnings Multiple Approach, 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.This article was written by Dividend Monk. If you enjoyed this article, please subscribe to my feed [RSS]
