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Monday, June 20, 2016

Using Absolute Stock Evaluation Methods for investing

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StockInvestingTips learning series: Many of the newbies of stock market doesnot know much about different stock valuation methods which needs to be known before shortlisting a company for investing your money. There are two different stock market evaluation methods namely:

1. Absolute Stock Market Valuation
2. Relative Stock Market Valuation

I'll explain these two stock valuation methods one by one, however this post would explain the Absolute Stock Valuation Method only. Relative Stock Valuation method would be explained in another post as I do not want to make this post too heavy for understanding. Step by step approach is better then a heavy dose.

Absolute Stock valuation methods can be applied using two approaches which are as follows:

1. Dividend Discount Method
2. Discounted Cash Flow Method

Here is explanation of both the above mentioned methods used for evaluating a stock:

Dividend Discount Method: The dividend discount method is one of the most basic absolute valuation method. The dividend method calculates the "true" value of a firm based on the dividends the company pays its shareholders. The justification for using dividends to value a company is that dividends represent the actual cash flows going to the shareholder, thus valuing the present value of these cash flows should give you a value for how much the shares should be worth. So, the first thing you should check if you want to use this method is if the company actually pays a dividend. Secondly, it is not enough for the company to just a pay dividend, the dividend should also be stable and predictable. The companies that pay stable and predictable dividends are typically mature blue-chip companies in mature and well-developed industries. These type of companies are often best suited for this type of valuation method.

A procedure for valuing the price of a stock by using predicted dividends and discounting them back to present value. The idea is that if the value obtained from the DDM is higher than what the shares are currently trading at, then the stock is undervalued. Stock Value = (Dividend per share)/(Discount rate - Dividend growth rate)

This procedure has many variations, and it doesn't work for companies that don't pay out dividends. For example one variation is the supernormal dividend growth model which takes into account a period of high growth followed by a lower, constant growth period. The principal behind the model is the net present value of the cash flows. To get a growth number, one option is to take the return on equity (ROE) and multiply it by the retention ratio.

Second type of Absolute stock market valuation method is the Discounted cash flow Method: What if the company doesn't pay a dividend or its dividend pattern is irregular? In this case, move on to check if the company fits the criteria to use the discounted cash flow method. Instead of looking at dividends, the DCF method uses a firm's discounted future cash flows to value the business. The big advantage of this approach is that it can be used with a wide variety of firms that don't pay dividends, and even for companies that do pay dividends, such as company XYZ in the previous example.

The Discounted cash flow Method has several variations, but the most commonly used form is the Two-Stage DCF method. In this variation, the free cash flows are generally forecasted for five to ten years, and then a terminal value is calculated to account for all of the cash flows beyond the forecast period. So, the first requirement for using this model is for the company to have predictable free cash flows, and for the free cash flows to be positive. Based on this requirement alone, you will quickly find that many small high-growth firms and non-mature firms will be excluded due to the large capital expenditures these companies generally face.

Discounted cash flow (DCF) is a valuation method used to estimate the attractiveness of an investment opportunity. DCF analysis uses future free cash flow projections and discounts them (most often using the weighted average cost of capital, which we'll discuss in section 13 of this walk through) to arrive at a present value, which is then used to evaluate the potential for investment. If the value arrived at through DCF analysis is higher than the current cost of the investment, the opportunity may be a good one.

The formula for calculating DCF is usually given something like this: Stock Value = CF1 / (1+k) + CF2 / (1+k)2 + … [TCF / (k - g)] / (1+k)n-1
PV = present value
CFi = cash flow in year i
k = discount rate
TCF = the terminal year cash flow
g = growth rate assumption in perpetuity beyond terminal year
n = the number of periods in the valuation model including the terminal year

There are many variations when it comes to what you can use for your cash flows and discount rate in a Discounted Cash Flow analysis. For example, free cash flows can be calculated as operating profit + depreciation + amortization of goodwill - capital expenditures - cash taxes - change in working capital. Although the calculations are complex, the purpose of Discounted Cash Flow analysis is simply to estimate the money you'd receive from an investment and to adjust for the time value of money.

Discounted cash flow methods are powerful, but they do have shortcomings. Discounted Cash Flow method is merely a mechanical valuation tool, which makes it subject to the axiom "garbage in, garbage out." Small changes in inputs can result in large changes in the value of a company. Instead of trying to project the cash flows to infinity, terminal value techniques are often used. A simple annuity is used to estimate the terminal value past 10 years, for example. This is done because it is harder to come to a realistic estimate of the cash flows as time goes on.

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