The Art and Science of Stock Valuation

In Finance 101, the first thing that you learn about is the “Time Value of Money”. Essentially, it means that a dollar today is worth more than a dollar tomorrow. The rest of the course of Finance 101 is to determine how to value different types of securities. Let’s do a quick overview into valuing future cash flows.

There are several components to a valuation.

  1. Net Present Value – What you’re calculating
  2. Discount Rate – What you’re using to bring tomorrow’s dollars to today’s dollars
  3. Growth Rate – Will the cash flow grow? If so how much?
  4. A Series of Future Cash Flows – The result of the growth rate

As analysts, our job is to calculate the Net Present Value of Future Cash flows by projecting out a some (hopefully) predictable growth of those flows, and discounting each future period of cash flow. That’s a mouthful so we’ll break it down.

Discount Rates

These are typically somewhat difficult to find, but for valuing equities / stocks there are a couple resource that you can use to find it. I use finbox (referral link). Since we are looking to value an equity we need to find a Stock’s Cost of Equity.

On finbox you’ll want to use the CAPM model, the link above goes to AT&T’s CAPM model. Finbox will list the components of a company’s cost of capital. We’re specifically looking for “Cost Equity” which I’ve circled in the image.

Cost of Equity tells us what an investor would expect to receive in returns if it was fairly valued.

Growth Rates

The Art of Valuation lies in divining the growth rates of companies over time. Financial analysts care less about earnings and more about cash flow. Therefore you’ll rarely see any financial model use some sort of earnings based analysis. Instead you’ll often see something like free cash flow which accounts for non-cash expenses and capital expenditure and reinvestment.

At this link finbox attempts to determine a growth rate into perpetuity as part of their dividend discount model. AT&T is a slow growing company, therefore the revenue component of their model seems to dominate the thinking of their overall growth rate.

This makes sense as AT&T is a very mature company with very small growth prospects. They effectively now have to buy very large companies to grow revenue or rely on small price increases over their customer base.

Projecting Cash Flows

There’s a number of ways to project cash flows. For mature and slower growing companies, you’ll typically find a single stage cash flow model works well. The simplest of these is the Dividend Discount Model. This model takes the cash flow generated by the company and projects out a constant growth rate. It then takes those cash flows and discounts them back to the present.

In this case, AT&T has a very high cash retention ratio. They generate Too Much Money! But as dividend investors we use that to our advantage.

Calculating Net Present Value

Since we’ve decided to use a stable growth rate, there’s no need to do anything special. We plug it into our Dividend Discount Model equation.

We’ll use the midpoint of $1.46/share with a 8.4% cost of equity and 3% risk free rate.

Net Present Value = ($1.46 x 1.025) / (8.4% – 3%) = $27.71

While money twitter is saying buy AT&T under $30, maybe they should be saying buy it under $28!

As an analyst, the main lever we have for this model is the dividend growth rate. If we believe that AT&T can grow their dividend at greater than 2%, then the value of the stock will be higher. That’s why it’s nice to do a scenario analysis with various growth ratios. It lets you see how sensitive a model is to growth inputs.

As we can see there’s a lot that goes into valuing a stock. Projecting the future is always difficult, but you can use a company’s past performance to make some intelligent guesses.

In the future I’ll cover multi-stage growth models and CAPM in slightly more detail.

Shameless Plug

In the spring I made the decision to suspend blog ads because they were very detrimental to the reader experience. However, if you’d like you can support the dividend growth cause in other ways.

If you don’t know, I have written a book on my dividend growth investing strategy called Too Much Money. Here’s 25% discount to normal price using this link just for being a blog reader.

Additionally, I’ve built a dividend web application that complements the book. I use it to find great stocks, add them to my watchlists, and perform my first pass of research.

Overall, over 2,000 people have benefited from the products and I’m humbled that so many people have decided to part with their hard-earned dollars to let me help improve their own financial situation! So thank you for the support!

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