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Let’s Learn Stock Valuation With Various Methods

For an investor, calculating or estimating a company’s stock valuation is very important in making investment decisions.

By calculating the valuation of the stock, the investor can identify whether the company’s stock price is overvalued, undervalued, or is fit to be at its reasonable value (market price).

“Come on, are you a retail stock investor in the pandemic era?, do you buy stocks by calculating the valuation first, or just following the trend, or maybe just based on your feelings? 🙂

For a CEO or top management of a company, understanding stock valuations is very important in order to take the right business decisions that can increase the stock valuation of the company he/she leads.

For a worker in a company, by understanding the valuation of the company’s shares, it will certainly be able to contribute more optimally in an effort to increase the valuation of the company, which will ultimately affect the welfare of its workers.

For a stock investor, there are two common analytical approaches used as the basis for investment decision making, namely:

  • Technical analysis, based on historical data on the company’s stock price movements.
  • Fundamental analysis, based on the operational and financial health condition of the company (which can be reviewed from its financial statements), related industry conditions and general economic conditions.

Technical analysis is generally used for short-term investment purposes, while fundamental analysis is required for long-term investments.

These two approaches can be combined so that considerations in making investment decisions are more comprehensive.

For example, fundamental analysis to choose which companies are fundamentally good and have high growth prospects, while technical analysis is used to choose the right time to enter (buy the company’s shares).

The stock valuation that I will describe in this article is fundamental analysis, which is how to calculate and assess the fairness of a company’s stock price.

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Summarized from several sources (notably Lawrence J Gitman & Chad J.Zutter, “Principles of Managerial Finance” 13th Edition and Investopedia.com), I will explain the various methods in calculating stock valuation, certainly equipped with examples to make it easier to understand.

Before getting into the calculation method, as an introduction, let’s first understand the factors that are important in the valuation of a company’s stock and how to estimate the growth of a company.

 

Important Factors in a Company’s Stock Valuation

“The value of a stock is essentially the present value of all the company’s future cash flows (dividends) up to an infinite time.”

The company’s future cash flow (dividend) is estimated by several methods and using certain growth assumptions.

The most common formula used in a company’s stock valuation is the “Gordon Growth Model”, assuming a company’s cash flow (dividend) grows at a constant rate, as follows:

From this formula, we can interpret it as follows:

gordon growth model
Gordon Growth Model For Stock Valuation
  • The valuation of the stock is directly proportional to the nominal expected dividend the following year (D1), the greater the dividend expected to be generated, the higher the valuation value of the stock, and vice versa.
  • Required return on common stock, this is the expected return rate of investment in the stock. The value for this required return can use the company’s weighted average cost of capital (WACC).

Weighted average cost of capital (WACC) is the weighted average of a company’s capital costs. WACC is defined as follows:

wacc_formula
Formula Weighted Average Cost of Capital (WACC)

More details about WACC can be read in my article:

Understanding Weighted Average Cost of Capital (WACC) Calculations

Required return or WACC is inversely proportional to the valuation of the company’s shares, the greater the required return, the smaller the valuation of its shares and vice versa.

  • Dividend growth rate, this is directly proportional to the valuation of the stock, the higher the growth potential of the company in the future, the higher the valuation of the company’s shares.

* Important note: 

The nominal value of this dividend needs to be observed also in a ratio (dividend pay-out ratio), which is compared to the total net profit of the company (earnings available to common stockholders).

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Companies that share most of their profits in dividends, indirectly miss the opportunity to reinvest those profits to pursue growth.

And vice versa. Companies that have low pay-out dividends (most retained earnings become retained earnings for later reinvestment), potentially having higher growth.

Usually companies that are rapidly growing will have a small dividend pay-out ratio, while companies that have established and stabilized their business will have a larger dividend pay-out ratio.  

 

How to Estimate a Company’s Growth?

One of the key points in stock valuation is how do we estimate a company’s growth?

One approach is based on historical growth data in previous years with the compound annual growth / CAGR method.

CAGR formula
Formula Compound Annual Growth (CAGR)

“But keep in mind that the growth that occurred in the Company’s past is not a guarantee that the company will grow at the same rate in the future”

Another indication that we can use to estimate the Company’s growth is the Company’s Financial Statements:

  • In The Income Statement we can look at how the growth of revenue compared to the increase in its costs.
  • In The Balance Sheet we can see the growth of its assets, is it more financed by debt or an increase in owner’s equity?
  • In The cashflows statement we look at how the change in the company’s cash flow, does the operational activity generate positive cash flow?, What about the company’s financing activities, does the company add new debt or pay off their previous debt?
  • We also need to explore the company’s capital expenditure (CapEx) on Cash Flow from Investment Activities, whether the company aggressively conducts new investments (which is one of the signals of future growth), 

or, whether the cash flow from the company’s investments is positive, which means the company is selling a portion of its assets (this is a bad signal, especially if the one being sold is a productive asset).

  • From Cashflows Statement and The Statement of Shareholder’s Equity, we can look at dividend payments, dividend pay-out ratios, and whether companies are trying to find financing from the issuance of new shares?
  • From the financial ratios of the company we can analyze the level of the company’s health, how its profitability ratios, liquidity ratios, debt ratios, activity ratios, and market ratios.  

We can analyze this ratio in a time series, or compared with similar companies to assess whether the company is healthy enough and on the right track to grow or vice versa.

Like the results of medical check-ups that are indicators of a person’s health, financial statements and financial ratios are indicators of a company’s health.

A healthy company certainly has better potential growth than a sick company.

More details about this can be read in my article which explores the details about the financial statements and financial ratios as follows:

Understanding 4 Types of Company Financial Statements

Understanding The Financial Ratios for Analysis of Company Performance

In addition to the health of the company itself, the company’s potential growth is also determined by external factors, including:

  • What in general are the economic growth prospects of the country going forward (as well as the global economy)?
  • Are there any government regulations or policies that impact the company’s business?
  • Prospects of similar industries in general
  • What is the trend of future market needs for products and services produced by the Company? Is there a technological development that has the potential to change the needs of the market (potential disruption), or is there a substitute product that will replace the type of product produced by the company?
  • To what extent the company is adaptive to the changing trend,
  • What about competitors?, does the company have the potential to outperform its competitors or vice versa.

This combination of various internal and external factors that affect the company’s growth.

No one can guess for sure how a company grows in the future (because investors are not necromancers 🙂

There will always be risk and uncertainty in investing. What we can do is try to make the most accurate estimates possible with the available data, and the rest is just assumptions that could be different between one investor and another.  

 

Various Methods in Company Stock Valuation

OK, now we discuss various methods of calculating the valuation of company shares.

To make things easier, on each method, I will present an example case, using an imaginer company, let’s say named “danieel.id Bersaudara“, engaged in textiles.

Weighted average cost of capital (WACC) of this imaginer company we have calculated in the article Understanding Weighted Average Cost Of Capital (WACC) Calculations (i.e. 10.34%)

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1. Stock Valuation with Dividend Growth Method

As explained earlier, the value of a stock is basically the present value of all future cash flows (dividends) of the company until an infinite time.

Although actually shareholders can sell their shares to get capital gains, actually the value paid by investors for a stock is the right to earn dividends in the future.

What if at a certain period, a company decides not to distribute dividends (all profits are made as retained earnings), or the dividend pay-out ratio is very small?

Still this means the potential to get dividends in the next period becomes greater, because retained earnings if invested properly will actually increase the company’s growth.

The basic formula for calculating the stock valuation of dividends is as follows:

Basic Stock Valuation Formula
Basic Formula For Calculating Stock Valuation

The formula can be simplified by defining dividends in a given year as a growth function of the previous year’s dividend.

There are three approaches related to growth, namely: zero growth, constant growth and variable growth. Let’s talk about it one by one:

1.1. Zero Growth Model

In this model, it is assumed that there is no dividend growth at all, meaning that the first year dividend is exactly the same as the second year dividend, the same as the third year dividend and so on.

zero growth model

If entered in the basic formula above then simplified, the stock valuation formula with zero growth is as follows:

zero growth model
Zero Growth Model on Stock Valuation

example case:

An investor (Let’s say Fulan) plans to buy shares of the “danieel.id Bersaudara” Company.

If he expects the company’s dividend will remain the same as the previous year’s dividend, which is Rp 354 per share each year, 

and required return he expects from investing in the stock is 10.34%, so the valuation of the “danieel.id Bersaudara” share is:

Note: we can use weighted average cost of capital (WACC) of the company as the required return

We enter the available data on the case into the zero growth model formula.

So the stock valuation “danieel.id Brothers” = D1 /rs = (Rp 354/10.34%) = Rp 3,424

Ok, now the investor can compare the valuation of the stock with the actual stock price of “danieel.id Bersaudara” in the market at that time.

If the valuation of the stock he calculated earlier is greater than the actual stock price, then it means that the company’s stock price is currently in an “undervalued” position or below the actual potential price. It’s an opportunity to buy those shares cheaply. 

Conversely, if the valuation of the stock he calculated earlier is smaller in value than the actual stock price of the company in the market, then it means that the company’s stock is in an “overvalued” position, or too expensive.

 

1.2. Constant Growth Model

The Constant Growth Model, also known as The Gordon Growth Model, is the most commonly used approach to valuing stock valuations.

In this approach it is assumed that the dividend of a company’s shares will grow at a fixed rate every year.

So that dividend in year t (Dt) = current dividend (D0) multiply by growth (1 +g) power t:

gordon growth model

If included in the basic formula of stock valuation as previously described, then simplified, the stock valuation formula with constant growth is as follows:

example case:

Fulan (an Investor) plans to buy shares of the Company “danieel.id Bersaudara”.

This investor estimates the company’s dividend growth based on historical data, namely with compound annual growth (CAGR) dividend paid by “danieel.id Bersaudara” over the past 6 years.

(then make adjustments based on Fulan’s confidence in the Company’s potential growth, after studying the company’s fundamental condition through its financial statements, general economic growth and other external factors)

Here is the historical data of dividend “danieel.id Bersaudara” 2015 – 2020:

historical_dividend
historical dividend data “danieel.id Bersaudara”

Fulan calculated the company’s growth dividend from historical data with a CAGR formula:

CAGR = ((354/280)^(1/5))-1 = 4.8 %

Fulan makes this CAGR as the basis of initial estimates for the company’s growth, then makes adjustments based on internal and external factors as mentioned earlier.

Fulan expects the company’s “danieel.id Bersaudara” growth in 2021 and the following year at 4.5%.

The required return is the same as the company’s weighted average cost of capital (WACC) of 10.34%.

So the valuation of the “danieel.id Bersaudara” shares is:

First we calculate the dividend in the following year (in 2021, in this case D1): that is, the last year dividend (in 2020) multiplied by the growth of 4.5% 

= Rp 354 x (1 + 4,5 %) = Rp 370

Then we enter the data available in the case into the formula constant growth model.

So the valuation of the stock “danieel.id Bersaudara” =

 D1/(rs – g)  = 371/(10,34% –  4,5 %) = Rp 6.334

This valuation value is much greater than the zero growth model method.

We can see here, if the company (potentially) grows, then the valuation will increase. The greater the growth, the greater the valuation of its shares.

 

1.3. Variabel Growth Model

Variable growth models can be used if a company’s growth potential is estimated to vary.

For example, because there are certain technological breakthroughs by the company, or certain regulatory changes that affect the Company’s business, or anything else that will cause the Company’s growth for the next few years to be much higher or much lower than normal circumstances.

In this approach, broadly speaking, we divide the period of growth of corporate dividends, namely:

  • Initial growth (g1) where there is significant growth in a given year, say until the end of the N-year, and
  • Stable growth (g2), where the growth of the company is estimated to be stable and constant at a certain rate.

The steps to calculate the valuation of the company with variable growth model are as follows:

Step 1 :

Calculate the dividend value each year in the initial growth period g1 (from year 1 to year to N)

The following formula is used to calculate the value of dividends each year in the initial growth period:

Step 2 :

Calculate the present value of dividends each year in the initial growth period. Here is the present value formula:

Formula For Calculating Present Value
Formula For Calculating Present Value

Step 3 :

We calculate the valuation of the stock at the end of the initial growth period, in the following way:

      • First, using the growth rate in a stable period (constant) – g2, calculate the dividend value in the year N + 1 (the first year of the period of stable growth)

      • Then we use the constant growth model to calculate the valuation of the stock at the end of the initial growth period:

      • Then, we calculate the present value of the stock valuation at the end of the initial growth period.

Step 4 :

The present value of dividends each year in the initial growth period that we calculate in step two above, with the present value of the stock valuation at the end of the initial growth period that we calculate in step 3

“How?  Still confused, huh?” 🙂

 

Let’s try the example case:

Still with the investor we named Fulan earlier, and imaginer company “danieel.id Bersaudara

This time Fulan considered buying shares of “danieel.id Bersaudara“, where the company is growing rapidly, because it has just applied the latest technological breakthroughs to its products that are in high demand by the market.

The latest dividend distributed by the company (in 2020) is Rp 354 per share.

Fulan estimates that due to the latest technological breakthroughs in the company “danieel.id Bersaudara”, the company’s dividend will increase by 10% (g1) every year, at least for the next 3 years (2021,2022,2023), before returning to the normal growth rate of 4.5% (g2) per year.

The rate of return he expects is equal to the company’s weighted average cost of capital (WACC) of 10.34%.

So, in this case, the valuation of the “danieel.id Bersaudara” shares is:

Ok, we apply 4 steps as explained earlier in this case:

Step 1:

We calculate the dividend value every year in the initial growth period g1 = 10% (from 2021 to 2023), as follows:

Annual Dividend “danieel.id Bersaudara” During Initial Growth Period

 

Step 2:

We calculate the present value of dividends each year in the initial growth period [PV2020(1)] as follows:

From the calculations as in the table, we get:

PV2020(1) = Rp 1,055

 

Step 3:

First, using the growth rate in the stable period (constant) – g2, calculate the dividend value in 2024 (the first year of the period of stable growth), as follows:

D2024 = Rp 471 x (1 + 4.5%) 

D2024 = Rp 492

Then we use the constant growth model to calculate the valuation of the stock at the end of the initial growth period (2023):

P2023 = Rp 492 / (10,34% – 4,5 %)

P2023 = Rp 8.431

Then, we calculate the present value of the stock valuation at the end of the initial growth period (2023):

PV2020(2)  =  Rp 8.431 / (1+ 10,34%)3

PV2020(2)  = Rp 6.276

 

Step 4:

We add the present value of dividends each year in the initial growth period that we calculate in step two above [PV2020(1)], with the present value of the stock valuation at the end of the initial growth period that we calculated in step 3. [PV2020(2)]

PV2020 = Rp 1.055 + Rp 6.276

PV2020  =  Rp 7.332

The valuation of shares “danieel.id Bersaudara” using this Variable Growth Model method is Rp 7,332 per share

Because of the high growth in the first three years, the valuation value of shares with this variable growth model, of course, is higher when compared to the previous stock valuation model (zero growth and constant growth model).

Let’s continue to page 2, we will discuss Stock Valuation with Free Cash Flow Growth Method

This post is also available in: Indonesian

Daniel
Danielhttps://danieel.id
Lahir di Palembang pada bulan November 1981, saya menyelesaikan S1 di Jurusan Teknik Kimia Universitas Sriwijaya, dan S2 Master of Business Administration (MBA) di Sekolah Bisnis Management Institut Teknologi Bandung (SBM-ITB). Bekerja di salah satu BUMN dan tinggal di daerah Jakarta Selatan.

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