A stock's value is the sum of all its future cash flows. If you expect dividends to grow each year, this suggests the stock has infinite value. But money you invest in stocks comes at an opportunity cost — the rate of return on alternate investments. To accurately value your stock, you must therefore discount its cash flows. Discounting cash flows considers the difference between the discount rate, which is your desired rate of return, and the stock's expected growth rate.
1. Add one to the stock's expected growth rate. For example, if the stock's dividends will grow by 12 percent each year, add 1 to 0.12 to get 1.12.
2. Multiply the stock's current annual dividends by this multiplier. For example, if the stock currently returns $1.04 per share, multiply $1.04 by 1.12 to get $1.1648.
3. Subtract the growth rate from your required rate of return. For example, if you want your investment to produce a 15 percent annual return, subtract 0.12 from 0.15 to get 0.03.
4. Divide the adjusted dividends from Step 1 by the difference from Step 3. Continuing the example, divide $1.1648 by 0.03 to get $38.83. This is the stock's value, accounting for discounted cash flows.
- This process assumes that the discount rate exceeds the stock's growth rate. If the growth rate exceeds the discount rate, the stock has an undefined value. It will produce the returns you desire no matter how much you must pay for its shares.
- If the stock's growth rate varies, calculate the stock's value for each year individually and add the values together.
- Fundamentals of Corporate Finance; Stephen A. Ross, et al.
- Investments: An Introduction; Herbert B. Mayo