Stock valuation

Lot of people think that investing is easy and lot of people think investing is hard. Actually if you ask me, it needs just 10th standard knowledge of mathematics and may be a calculator.

Investing in the stock market can be a challenging task, especially for those who are new to the game. Lot of these newbies get fooled by people mushrooming on social media as experts with barely any education or knowledge of stock valuation. Lot of these people drive business towards stock of their choice by promoting themselves another posts after taking position and then exit position once they have made money. Happened with some people I know so trying simplify and putting some simple concepts.

One of the most critical aspects of investing in stocks is evaluating them. Evaluating a stock involves analyzing its financials and determining its true value. In this blog, we will discuss some of the best methods to evaluate a stock, along with formulae. We will also provide an example to demonstrate how each of these methods works.

Dividend Discount Model (DDM)

The Dividend Discount Model (DDM) is a stock valuation method that values a stock based on the present value of the future dividends the company is expected to pay. The formula for DDM is as follows:

Stock Price = D / (r - g)

Where D is the expected dividend payment, r is the required rate of return, and g is the growth rate of dividends.

For example, suppose Company ABC has a current stock price of $100, pays an annual dividend of $5 per share, and the required rate of return for investors is 10%. The company is also expected to increase its dividend by 3% every year. Using the DDM formula, the stock price would be:

Stock Price = 5 / (0.1 - 0.03) = $71.43

This indicates that the stock is overvalued at the current market price of $100.

Weighted Average Cost of Capital (WACC)

The Weighted Average Cost of Capital (WACC) is a formula used to calculate the cost of financing a company's operations. The WACC is the average cost of debt and equity financing. This formula considers the proportion of each source of financing and the cost of each source.

WACC = (E/V x Re) + (D/V x Rd x (1-T))

Where E is the market value of equity, V is the total market value of the company, Re is the cost of equity, D is the market value of debt, Rd is the cost of debt, and T is the corporate tax rate.

For example, suppose Company XYZ has a market value of $1 billion, with $500 million in equity and $500 million in debt. The cost of equity is 12%, the cost of debt is 5%, and the corporate tax rate is 30%. Using the WACC formula, the calculation would be:

WACC = (500/1000 x 0.12) + (500/1000 x 0.05 x (1-0.3)) = 0.085 or 8.5%

This means that for Company XYZ to create value for shareholders, it needs to generate returns higher than 8.5%.

Discounted Cash Flow (DCF)

The Discounted Cash Flow (DCF) method is a valuation technique used to estimate the intrinsic value of an investment. This method is used to estimate the present value of the future cash flows generated by a company. The formula for DCF is as follows:

DCF = CF1 / (1 + r)1 + CF2 / (1 + r)2 + ... + CFn / (1 + r)n

Where CF is the cash flow generated by the company in each period, r is the discount rate, and n is the number of periods.

For example, suppose Company DEF has a current free cash flow of $100 million, which is expected to grow at 5% per year. The required rate of return is 10%, and we want to estimate the intrinsic value of the stock for the next 10 years. Using the DCF formula, the calculation would be:

DCF = 100 / (1 + 0.1)1 + 105 / (1 + 0.1)2 + 110.25 / (1 + 0.1)3 + ... + 163 / (1 + 0.1)10

This gives us a DCF value of $937.20, which represents the intrinsic value of the stock. If the current market price of the stock is higher than $937.20, it may be overvalued, and if it's lower, it may be undervalued.

It is not so difficult to read annual reports, go through transcripts of management and do these calculations yourself. There are always some gaps... Management (quality) is a clincher.

Share some profits if these methods help you make money..