Valuing a company is very important when it comes to fundamental investment, that is, for investors who plan to invest for a medium or long period of time. According to ‘Value Investors’, investing in a business is only worthwhile if its ‘Present value’ (also called ‘Intrinsic Value’ or ‘Fundamental Value’) is greater than its current market value. In simple words, a stock is worth investing in only if the current value of all expected earnings from this stock (in the form of dividends and capital appreciation) is greater than the current market value. When the present value (PV) is greater than the current market price, the stock is said to be bought. ‘undervalued’ and when it is less than the market value, the stock is said to be ‘Overvalued’.

For example, consider the shares of Company A with a current market price of $20. A value investor will consider investing in this stock only if they feel the intrinsic value is greater than $20. That is, it assumes that company A is ‘undervalued’. Conversely, if the PV is less than $20, an investor may consider selling it short. It’s important to remember that a cheap stock is not necessarily “undervalued.” A low price may reflect poor market sentiment or a general economic downturn and does not necessarily mean it is undervalued.

The PV is calculated by discounting all of a stock’s expected future earnings using the investor’s expected rate of return. These earnings can be in the form of dividends and capital gains.

Dividend discount method (DDM)

This is the most familiar method applied to valuing companies that have consistently paid dividends to their investors over the past few years, and are expected to pay dividends in the years to come as well. Mature companies generally pay dividends regularly and are valued using this method. DDM can be modified for companies that are expected to grow steadily at the same rate, or at a higher rate for the first few years, and then grow at a lower rate. The following are some of the commonly used DDM formulas.

Companies that are expected to pay a constant dividend per share in perpetuity can be valued as:

Present value = Dividend per share / Discount rate

This is the most basic DDM formula. However, its biggest flaw is that it assumes zero growth, which is taken care of in the following formula:

Present value = Dividend per share / (Discount rate – Dividend growth rate)

Companies that are expected to grow at a constant rate in perpetuity can be valued using this formula, which is also known as the Gordon Model or constant growth DDM. However, it cannot be applied if the dividend growth rate exceeds the investor’s rate of return, as the denominator will be negative and the value of a share can never be negative.

The DDM can be further modified as a multi-stage DDM to value companies that are expected to grow initially at variable rates and then at a constant rate in perpetuity. For example, a company, say, A, can be expected to grow at 10% per year for the first 3 years, 7% for the next 3 years, and then 4% in perpetuity.

When applying DDM to value stocks, investors should keep in mind that the calculated value will only be as good as their assumptions applied in DDM. Many assumptions must be applied when valuing a stock using DDM. An investor must have a strong fundamental understanding of the company to determine its earnings growth rate and dividend payout rate, in addition to knowing its own risk-adjusted rate of return. Understanding your risk profile will allow you to set a realistic expected rate of return. Therefore, the PV of a stock will be different for each investor. The higher the expected return, the lower the PV. Similarly, the longer the period of time to hold the shares, the lower the PV.