The primary financial benefits of investing in stocks include earning dividends and capital gains. Before investing in common stock, investors calculate the value of the stock to determine if the market price is a bargain or is overvalued. Several methods exist for calculating common stock value. Investors should understand the methods for stock valuation to determine if a stock is a potentially profitable investment.
An investor purchasing stock must determine the expected return, or discount rate, they desire to earn from the stock. Two assumptions are made when calculating the expected return. The assumptions include the future value of the stock in one year, and the future value of dividends paid by a company. The expected return is calculated by adding dividends paid to capital gain, and dividing the total by the stock price. For example, assume the current price of a stock is $100, the value of the stock is estimated at $110 one year from now, and the expected dividend paid is $5. Therefore, the expected return is 15 percent ($5 + $10/$100).
Estimating the dividend growth rate is an important component of calculating common stock value. Investors make assumptions that a company’s return on equity and the payout ratio remain constant when estimating the dividend growth rate. The dividend growth rate is calculated by multiplying the plowback ratio to return on equity. The plowback ratio equals one minus the payout ratio, while the payout ratio equals dividends paid divided by earnings per share. The payout ratio equals the percentage of earnings paid out as dividends.
The constant growth method is generally used for financially sound companies that investors expect to pay dividends perpetually. The formula for the constant growth model is stock price equals dividends divided by the difference of expected return, minus the growth rate. The method is based on assumptions that dividends are expected to grow at a constant rate. To calculate the value of a stock using the constant growth model, investors must calculate the rate of return and estimate the dividend growth rate. For example, if a company expects to pay $3 in dividends for the next period, and dividends grow 5 percent every year after with a discount rate of 10 percent, the value of the stock is $60 ($3/(0.10 - 0.05)).
Discount Cash Flow
The discount cash flow model calculates the present value of a stock by determining its estimated future cash flows. Investors who know, or can estimate, the number of years they plan to hold the stock can use the discount rate to calculate the common stock value. For example, assume the current price of the stock is $100, the dividend growth rate is 6 percent, the discount rate is 8 percent and the investor plans to hold it for 100 years. The first step is to calculate the value of the stock in 100 years, which is $33,930.21 (($100 x (1.06^100)). The next step is to discount the selling price by the discount rate, which equals $15.44 ($33,930.21/$2199.76). Therefore, $84.56 of the stock's value is attributed to the present value of future dividends.
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