Many of us wonder if we are overpaying for our investments. For this, understanding the true value of a stock is essential. So how do we go about finding out whether the company is overvalued or undervalued? To ascertain the intrinsic value of a stock, we need to first learn about equity valuation and the models which are used to estimate the real value of a stock.
But let us first understand the importance of intrinsic value.
By analyzing the intrinsic value of a security or a stock, the analyst can arrive at three conclusions -whether the stock is undervalued, overvalued or fairly valued. For example, if stock ABC’s market price is Rs. 100 and the analyst estimates that the intrinsic value is Rs. 80, we can say that the stock is overvalued.
Similarly, if a stock is priced Rs. 80 but its intrinsic value is Rs. 100 we can say that the stock is undervalued. But we should remember that intrinsic value is not the only parameter to select a stock. Investors’ confidence in his analysis and the likelihood of the market price actually moving to the true price or real price of the stock is also necessary.
Now, let us move to the core topic of the discussion which is discounted cash flow model.
Discounted cash flow model simply tries to ascertain the value of the company today based on the future projections.
It is known as the discounted model as the future value is always worth less than today. In simple terms, if you were given a choice to take Rs. 1,000 today or after 1 month, chances are more likely that you would take the money today.
There are several methods of calculating discounted cash flow but in this article we will focus on dividend discount model.
Dividend discount model
Value of a stock (V) = Dividend per share (D)/ cost of equity (k) – dividend growth rate (g))
Whenever investors invest in a stock they expect two types of cash flows: 1) dividend 2) price appreciation
Since the future cash flows would include dividends, the dividend discount model assumes expected dividend based on future growth projects to value the present value of the stock by discounting the future cash flows.
There are three basic inputs in this model – 1) expected dividend that is projected from the future earnings and 2) the cost of equity which is derived from the CAPM model. (Click here to read our tutorial on CAPM for reference) and 3) growth rate is the estimated rate by which the company or a sector would grow.
Types of Dividend Discount Models:
- Gordon Growth Model
The Gordon Growth Model is used to determine the intrinsic value of the stock based on future dividends. The model assumes that the dividend grows at a constant rate.
As the model assumes a constant growth rate, Gordon Growth Model is more feasible for companies which have stable growth rate in dividend per share.
Value of the stock = DPS/ k-g
DPS = dividend per share one year from now
k= cost of equity
g= constant growth rate
- Multi-stage dividend discount model
Multi-stage dividend model is where a company clocks a growth rate that actually exceeds the required rate of return (ROE) on firm’s equity but they cannot sustain this growth forever.
This is because when a company gives higher than expected growth it attracts competition and the growth will soon fall and eventually the growth rate will be stable.
V= D1/(1+K) + D2/(1+k)2 + D3/(1+K)3 + … Dn/(1+K)n + Pn/(1+K)n
Steps in multistage model:
- Determine the discount rate (K)
- What is the project size and the duration of the high growth rate period
- Estimate dividends that are coming in during the high growth period
- To estimate the growth rate (constant) after the high growth period ends
- Estimate first dividend at constant growth rate
- Use the constant growth rate to calculate the value of the stock at the end of high growth period
- Add PV of all dividends to PV of the final value of the stock
That’s all folks!
Let us know if you have any doubts or want us to write about a specific topic.
