Have you ever watched a stock price fall and immediately thought, “Wow, that’s cheap!”? I prefer to invite us to pause for a moment: cheap compared with what? Stock valuation helps us estimate a business’s fair value, so we can compare its market price with the company’s ability to deliver value to shareholders.
Fundamental analysis examines the business, its financial statements, and its prospects; technical analysis examines price movements and trading volume. Both can serve a purpose, but here we focus on stock valuation. The result is an estimate based on assumptions, not a price the stock is certain to reach.
Disclaimer: companies X and Y and all figures in this article are hypothetical examples for learning. The choice of examples does not imply a recommendation to buy or sell, or a particular judgment about any real company. This article is not personal investment advice. Check actual data, assess the risks, and consider whether a decision fits your own circumstances.
Key factors: cash flow, risk, and growth
In stock valuation, the three main drivers of value are cash flow, growth, and the discount rate. Larger cash flows tend to increase value, while greater risk, reflected in a higher discount rate, tends to reduce it. Growth creates value only when the investments supporting it earn an adequate return.
We need to match cash flows with the appropriate discount rate: dividends and FCFE use the cost of equity (ke), while FCFF uses WACC. FCFE is available to shareholders after investment needs and debt financing are accounted for; FCFF is available to all providers of capital before payments to them.
For a capital structure without preferred shares, E and D are the market values of equity and interest-bearing debt, kd is the pretax cost of debt, and T is the relevant tax rate. If preferred shares are present, add their market-value weight multiplied by their cost, with all weights adding up to one. Explore the context in WACC calculation and the cost of equity using CAPM.
How can we estimate growth?
Start with trends in sales, margins, working capital needs, capital expenditure, debt, and dividend policy. Read about the four types of financial statements alongside company financial ratios. Industry conditions, regulation, competition, and technology also influence forecasts.
n is the number of intervals, not the number of observations. A hypothetical dividend rising from Rp280 to Rp354 over six annual observations has five intervals; its CAGR is approximately 4.80%. This history is only a starting point, not a guarantee of future growth. Special dividends and stock splits need to be adjusted for a like-for-like comparison.
Retained earnings do not automatically increase value: look at the quality of reinvestment. Positive cash flow from investing activities is not automatically bad, either; it may come from selling unproductive assets or cashing in investments. In stock valuation, we need to understand the business reasons behind the numbers.
Stock valuation using dividend growth
The Dividend Discount Model (DDM) works well when dividends reasonably reflect a company’s ability to distribute cash. Today’s value is the sum of the present values of expected dividends. In this model, a future selling price reflects dividends after the sale date.
P0 is the current value per share, Dt is the dividend per share at the end of year t, and ke is the cost of equity. Our example for company X uses D0 = Rp354 (Indonesian rupiah) and ke = 12% a year. The 12% figure is an assumption for this exercise, separate from the 10.34% WACC in the FCFF example.
Zero growth: a fixed dividend
If the dividend stays at Rp354 every year indefinitely, P0 = Rp354 ÷ 12% = Rp2,950. This simplification requires a sustainable dividend and a positive cost of equity. A value above the market price suggests potential undervaluation under the model’s assumptions, not an automatic buying opportunity.
Constant growth: the Gordon Growth Model
g is the constant dividend growth rate and must be lower than ke. With g = 4.5%, D1 = Rp354 × 1.045 = Rp369.93. Therefore, P0 = Rp369.93 ÷ (12% − 4.5%) = Rp4,932.40. Keep full precision throughout the calculation, then round the final result.
Constant growth forever must be a reasonable assumption for a mature company. As g approaches ke, the estimated value rises sharply; if g is equal to or higher than ke, this perpetuity formula does not apply. Do not force the model to produce an attractive-looking result.
Variable growth: growth in stages
Suppose company X’s dividend grows by 10% for three years, then by 4.5% thereafter. The initial and stable growth rates differ, but the cost of equity remains 12% in this exercise.
| Year | Dividend | Present value |
|---|---|---|
| 1 | 389.40 | 347.68 |
| 2 | 428.34 | 341.47 |
| 3 | 471.174 | 335.37 |
PN = DN+1 ÷ (ke − g2)
D4 = Rp471.174 × 1.045 = Rp492.37683. The terminal value at the end of year three is Rp6,565.02; its present value is Rp4,672.85. Add the present value of the first three dividends, Rp1,024.52, to arrive at an estimate of Rp5,697.38 per share. The fourth-year dividend is included in the terminal value and is not added separately.
Stock valuation using free cash flow
Stock valuation can still use cash flows when a company does not pay dividends. However, we need to clarify what FCF means. Operating cash flow minus CapEx is a practical measure, but it is not automatically FCFF consistent with WACC; the treatment of interest and taxes needs to be checked.
If operating cash flow has already been reduced by all relevant interest payments, the approach FCFF = CFO + After-tax interest − CapEx can be used after reconciliation. Do not add interest back if it has not been deducted from CFO.
EBIT is operating profit before interest and taxes; EBIT × (1 − T) is NOPAT, or net operating profit after tax. D&A means depreciation and amortization, CapEx is capital expenditure, and ΔNWC is the increase in noncash operating working capital, excluding interest-bearing debt. An increase in ΔNWC reduces cash flow. Use reinvestment needs that support the projected growth.
The simplified FCFE formula above assumes no preferred shares; net debt issuance is new borrowing minus debt repayments. Discounting FCFE at ke gives equity value directly, so debt is not deducted again. Below, we follow the FCFF approach.
Here is a hypothetical example for company Y: FCFF for five consecutive years is Rp350, Rp378, Rp412, Rp447, and Rp482 billion; WACC is 10.34%; stable growth is 4% from year six onward. The condition is that g must be lower than WACC, with consistent currency and inflation assumptions.
TVN = FCFFN+1 ÷ (WACC − g)
FCFF6 = Rp482 × 1.04 = Rp501.28 billion. TV5 = Rp501.28 ÷ (10.34% − 4%) = Rp7,906.62 billion. After discounting the five FCFF amounts and the terminal value, we obtain an operating value of Rp6,364.85 billion. Year-five FCFF is counted once; the terminal value begins with year six.
Assume interest-bearing debt has a market value of Rp2,250 billion, preferred shares are worth Rp300 billion, excess cash is zero, there are no noncontrolling interests or other claims, and there are 600 million common shares. Common equity value = Rp6,364.85 − Rp2,250 − Rp300 = Rp3,814.85 billion. Value per share = (Rp3,814.85 billion × 1,000 million/billion) ÷ 600 million = approximately Rp6,358.08.
Interest-bearing debt differs from total liabilities: trade payables already reflected in working capital should not automatically be deducted again. Add excess cash only if it is not already included in operating value. For consolidated groups, treat noncontrolling interests consistently. The general FCFF model also needs special adjustments for banks and financial services companies.
Stock valuation using market ratios and asset values
Book value and price-to-book value
In a hypothetical example, assets are Rp4,510 billion, liabilities are Rp2,250 billion, preferred equity not included in liabilities is Rp300 billion, there are no noncontrolling interests, and there are 600 million common shares. Common equity is Rp1,960 billion, so BVPS = Rp3,266.67. At a price of Rp4,125, PBV = 1.26 times. If preferred shares are already classified as liabilities, do not deduct them twice.
Book value is an accounting measure, not cash that shareholders are certain to receive if the assets are sold. As with buying a restaurant, we assess the business’s ability to generate profit, not just its pots and tables. A low PBV can suggest a relatively low price, but it can also reflect problems with asset quality or profitability. PBV cannot be interpreted in the usual way when equity is negative.
Liquidation value
If estimated asset sale proceeds are Rp4,300 billion, all liabilities are Rp2,250 billion, preferred claims are Rp300 billion, and liquidation costs are assumed to be zero, Rp1,750 billion remains for common shareholders. With 600 million shares, the estimate is Rp2,916.67 per share. In practice, costs, taxes, the timing of sales, and the priority of claims can reduce the proceeds.
Liquidation value is not a guaranteed price floor. If priority claims exhaust the sale proceeds, common shareholders may receive nothing. An operating value below estimated liquidation value does not automatically mean the company should close, either; the assumptions, costs, and consequences still need to be examined.
Price-to-earnings ratio and comparable multiples
Earnings available to common shareholders of Rp345 billion, divided by a weighted average of 600 million shares, give EPS of Rp575. At a price of Rp4,125, PER = 7.17 times. If projected EPS is Rp575 and the hypothetical comparable PER is 7.18 times, indicative value = Rp4,128.50. This comparable PER is not an actual industry figure.
Use net income attributable to common shareholders after preferred shareholders’ entitlements, not NOPAT. Match a historical PER with historical EPS, or a forward PER with projected EPS. Check dilution, one-off earnings, and the business cycle. A low PER does not automatically mean a stock is cheap; if the company is loss-making, PER is usually not useful for conventional comparisons.
Checking actual data and sensitivity
Obtain the latest financial statements and notes from the Indonesia Stock Exchange’s financial statements page or the issuer’s investor relations website. Check the reporting period, currency, units, price date, dividends, and share count after corporate actions. For comparable ratios, use Indonesia Stock Exchange statistics and check the definitions and sector coverage in the publication you select.
For stock valuation using market ratios, comparable companies should have similar businesses, risks, and growth prospects. Do not simply use an industry average without examining loss-making companies or outliers. Note whether the data is annual, trailing twelve months, or forecast.
Test several assumptions in stock valuation. With D0 of Rp354, the Gordon model gives approximately Rp5,691 at ke of 11% and g of 4.5%, but approximately Rp4,352 at ke of 13% with the same g. This difference shows why a range of values is more useful than one seemingly certain number.
Closing thoughts
No single stock valuation method is always the best choice. Choose DDM when the dividend policy is representative, FCFF or FCFE when cash flows can be projected, then use ratios and asset values as comparisons appropriate to the business.
For me, the main benefit of stock valuation is that it makes our reasoning clearer: which assumptions we use, which risks we have not captured, and how much the result changes if our assumptions miss the mark. Compare several approaches without blindly averaging their results. I hope this helps us look at prices with a calmer perspective.
Sources
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