Common stock valuation models are essential tools for investors to determine a stock's intrinsic value. These models, including the Dividend Discount Model and Discounted Cash Flow approach, use future cash flows and growth rates to estimate fair prices.
Understanding these models is crucial for making informed investment decisions. However, it's important to recognize their limitations, such as reliance on accurate projections and sensitivity to key inputs. Conducting sensitivity analysis helps investors assess potential risks and returns.
Dividend Discount Model for Valuation
Constant Growth Model (Gordon Growth Model)
- Values a stock based on the present value of its expected future dividends, discounted at the required rate of return
- Assumes a stock's dividends will grow at a constant rate indefinitely
- Calculated as: P=D1/(k−g)
- P is the present value of the stock
- D1 is the expected dividend per share in the next period
- k is the required rate of return
- g is the constant growth rate in dividends
- Suitable for companies with stable, predictable dividend growth (mature companies)
Multi-Stage Dividend Discount Models
- Two-stage dividend discount model assumes a company will experience supernormal growth for a finite period before transitioning to stable growth
- Involves discounting the dividends during the initial growth phase and the terminal value at the end of the supernormal growth period
- Suitable for companies expected to have high growth followed by stable growth (emerging companies)
- Three-stage dividend discount model incorporates an initial period of high growth, a transition period of declining growth, and a final period of stable growth
- Each stage's dividends are discounted separately, and a terminal value is calculated for the final stage
- Suitable for companies with multiple distinct growth phases (high-growth companies)
- H-model is a two-stage model that assumes a company's dividend growth rate starts high and then declines linearly over time until reaching a stable growth rate
- Captures a gradual transition from high growth to stable growth
- Suitable for companies with declining growth rates over time (maturing companies)
DCF Model for Intrinsic Value
Free Cash Flow to Equity (FCFE) Approach
- Values a stock based on the present value of its expected future free cash flows to equity (FCFE), discounted at the required rate of return
- FCFE represents the cash flow available to equity holders after capital expenditures, working capital changes, and debt repayments
- Calculated as: FCFE=NetIncome+Depreciation&Amortization−CapitalExpenditures−ChangeinWorkingCapital+NetBorrowing
- Suitable for companies with significant debt or variable capital structures
Weighted Average Cost of Capital (WACC) as Discount Rate
- WACC represents the company's cost of financing from both debt and equity sources
- Used as the discount rate in the DCF model
- Calculated as: WACC=(E/V∗ke)+(D/V∗kd∗(1−T))
- E is the market value of equity
- D is the market value of debt
- V is the total market value of the firm (E+D)
- ke is the cost of equity
- kd is the cost of debt
- T is the corporate tax rate
- Incorporates the tax shield benefit of debt financing
Multi-Stage DCF Models
- Two-stage DCF model assumes a company will experience a period of high growth followed by a period of stable growth
- High-growth phase cash flows and terminal value are discounted separately
- Suitable for companies expected to have high growth followed by stable growth (emerging companies)
- Three-stage DCF model incorporates an initial high-growth phase, a transition phase, and a final stable growth phase
- Each stage's cash flows are discounted separately, and a terminal value is calculated for the final stage
- Suitable for companies with multiple distinct growth phases (high-growth companies)
Limitations of Valuation Models
Reliance on Accurate Projections
- Both dividend discount and DCF models assume that investors have access to accurate projections of future dividends or free cash flows
- Estimating future cash flows reliably may be difficult, especially for companies with volatile earnings or limited operating history
- Inaccurate projections can lead to significant valuation errors
- Models are sensitive to inputs such as the required rate of return and growth rates
- These inputs are based on assumptions and estimates that may not accurately reflect future conditions
- Small changes in inputs can result in large changes in the estimated stock price
- Constant growth model assumes a company can maintain a stable growth rate indefinitely, which may not be realistic for many firms
Non-Financial Factors
- Models do not explicitly account for non-financial factors that may impact a company's value
- Management quality
- Competitive advantages
- Industry trends
- Regulatory changes
- These factors can have a significant impact on a company's future performance and stock price
Reinvestment Assumption in DCF Model
- DCF model assumes that free cash flows are reinvested at the WACC
- In practice, companies may reinvest cash flows at rates higher or lower than the WACC
- This assumption can lead to over- or undervaluation of the stock
Sensitivity Analysis of Stock Valuations
Impact of Required Rate of Return (Discount Rate)
- Required rate of return has an inverse relationship with the stock price in both dividend discount and DCF models
- Higher required rate of return leads to a lower estimated stock price
- Reflects the increased risk or opportunity cost associated with the investment
- Example: Increasing the required rate of return from 10% to 12% may decrease the estimated stock price from 50to40
- Lower required rate of return results in a higher stock price
- Reflects the decreased risk or opportunity cost associated with the investment
- Example: Decreasing the required rate of return from 10% to 8% may increase the estimated stock price from 50to60
Impact of Growth Rates
- Growth rates have a direct relationship with the stock price in both models
- Higher growth rates lead to higher estimated stock prices
- Reflects the increased expected future cash flows or dividends
- Example: Increasing the dividend growth rate from 5% to 7% may increase the estimated stock price from 50to70
- Lower growth rates result in lower stock prices
- Reflects the decreased expected future cash flows or dividends
- Example: Decreasing the free cash flow growth rate from 10% to 8% may decrease the estimated stock price from 60to50
Length of High-Growth and Transition Periods
- In multi-stage models (two-stage and three-stage), the length of the high-growth and transition periods can significantly impact the stock valuation
- Longer high-growth periods generally result in higher stock prices
- Reflects the extended period of higher cash flows or dividends
- Example: Extending the high-growth period from 5 years to 7 years may increase the estimated stock price from 60to75
- Shorter high-growth periods result in lower stock prices
- Reflects the reduced period of higher cash flows or dividends
- Example: Reducing the transition period from 3 years to 2 years may decrease the estimated stock price from 70to65
Scenario Analysis
- Involves estimating stock prices under different sets of assumptions, such as base case, best case, and worst case scenarios
- Provides a range of potential outcomes based on varying input assumptions
- Base case scenario represents the most likely set of assumptions
- Example: Base case scenario with a required rate of return of 10% and a growth rate of 5% may result in an estimated stock price of $50
- Best case scenario incorporates more optimistic assumptions
- Example: Best case scenario with a required rate of return of 8% and a growth rate of 7% may result in an estimated stock price of $80
- Worst case scenario incorporates more pessimistic assumptions
- Example: Worst case scenario with a required rate of return of 12% and a growth rate of 3% may result in an estimated stock price of $30
- Analysts should consider a range of reasonable input values when conducting sensitivity analysis to assess the potential upside and downside risks of a stock investment