Stock Valuation

In Finance we have been studying stock valuation. Equilibrium stock prices represent the present value of a string of future cash flows. The cash flows that you receive when you invest in a company are the stream of dividends and the price you get when you sell the stock. The stock price that you expect to receive in the future is based on the present value of the future dividend. If you were to sell the stock one year from now the stock price would be based on the dividend you would receive in year two. If you were to hold the stock for an infinite period of time the process for calculating the stock price could go on ad infinitum.

There are several different models that can be used to calculate a company's stock price depending on the companies growth pattern. Is the company experiencing zero growth, consistent growth, or super natural growth? The constant dividend growth model is used for mature companies who experience consistent growth over an extended period of time. In order to calculate the stock price you have to know the company's growth rate and their required rate of return. To find the company's growth rate you can go to Yahoo Finance, and find the company's estimated growth rate for the next five years. The required rate of return is calculated using the CAPM model. The required rate of return is equal to the risk free rate (short-term treasury rate) plus the risk premium multiplied times the company's Beta. The risk premium is equal to the market's (S&P 500) average rate of return over at least one business cycle minus the risk free rate of return. The dividend one year from today divided by the difference between the required rate of return and the growth rate would give you the stock price today.

If a company is experiencing zero growth, the stock price today is simply the current dividend divided by the required rate of return. If the company is experiencing super natural growth where the rate of growth is rapid for the first several years with a slower more natural growth rate in future years, the method for calculating the stock price today is different than constant growth model. To calculate the stock's value today you take the sum of the present value of the future dividends during super natural growth plus the present value of the stock at the time the company resumes to a slower more sustainable growth pattern.

Another method for stock valuation is using the Free Cash Flow approach where the most recent free cash flow is discounted by the Weighted Average Cost of Capital minus the growth rate. I will touch on the WACC in next week's blog. You can also use the Market Multiple approach where you take the earnings per share times an average market multiple for similarly traded public companies. This method is more judgemental