Several common stock valuation methods are available for investors to calculate the value of a common stock prior to purchasing. This is an important component of the stock selection process as the information is used to determine whether the stock price in the marketplace bears any relationship to its true value.
The Dividend Discount Model
The Dividend Discount Model (DDM) is based on the concept that the value of a stock is equal to the present value of future dividends received by an investor from that stock over time. Present value is the current value of a cash flow received some time in the future.
The Zero Growth DDM assumes that dividends are constant and do not grow over time. The Zero Growth model is calculated as:
Price = Dividend / (Discount Rate)
The discount rate is chosen based on an assessment of the rate of return on risk free or government bonds plus a risk premium based on how risky stocks are to buy.
The Constant Growth DDM assumes that the dividend stream grows at a constant rate. The Constant Growth DDM is calculated as:
Price = Dividend / (Discount Rate – Dividend Growth Rate)
DDM Model Weaknesses
The various DDM models have inherent weaknesses that limit their application in the non-academic world. Predicting the growth in dividends over a multi-year time frame is difficult even for the management of a company, much less an outside investor. Many stocks do not pay dividends during the early stage rapid-growth period as the funds are needed for internal investment purposes. The value of a stock as calculated by the DDM is sensitive to the discount rate used, and different discount rate assumptions for the same stock can lead to widely divergent values particularly over the long time period used.
The price-to-earnings (PE) ratio is another method used to value common stocks. This ratio is calculated by dividing the price per share of the stock by the earnings per share. This value is then compared to the PE ratio for the market or sector, and the historical range of the stock. Investors can use different values for the denominator of the calculation based on their preferences.
The trailing 12-month PE ratio is calculated using the actual earnings per share for the last four quarters as the denominator. This method has the advantage of certainty in earnings since the data is historical, but is criticized for using stale information.
The forward PE ratio is calculated using the estimated earnings per share for the next four quarters. This estimation introduces uncertainty into the valuation method because estimates on future earnings can vary.
The price-to-sales (PS) ratio is calculated in a manner similar to the PE ratio, with the price per share in the numerator, but with sales per share in the denominator. The result is then compared to the historical PS range for the stock, or the industry.
The importance of using a stock valuation method was first promoted by Benjamin Graham, a noted investor who popularized the investing method now known as value investing in the early part of the twentieth century.