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To most investors, valuation models represent a black box best left to Wall Street professionals. Despite their complexity, it's wise for investors to possess a basic understanding of how they work and even perform some back of the envelope calculations. Two popular but different valuation techniques used in finance are the discounted cash flow model, which values a company based on its earnings, and the dividend discount model, which values a company based on its dividends.
The idea behind the discounted cash flow model is simple: estimate the future free cash flows that a company will generate and place a value on them. While this may sound easy in practice, it's extraordinarily difficult. Wall Street gurus build complex models that consider a wide range of variables, such as industry growth, market share and new product launches, but still have trouble getting it right. The second step is to discount the future free cash flows to express them in today's terms. The discount rate should also reflects the riskiness of the free cash flows. Thus, an early-stage, high-tech company would use a higher discount rate than a mature business such as a utility company.
Suppose that a company generates free cash flows of $100 million which have been growing by 2 percent annually. A simple DCF forecast might assume that this pattern will continue indefinitely. We would apply a growing perpetuity present value formula: present value = free cash flow / (discount rate - constant growth rate). If the appropriate discount rate for this business were 10 percent, then the present value of its future free cash flows would be $1,250 million: 100 / (0.10 - 0.02). If the company had 10 million shares outstanding and were debt-free then its stock should be trading at $125 per share (1,250 / 10).
The dividend discount model discounts future dividend payments instead of free cash flows. Thus, the value of a stock today is the sum of the present value of its future dividends. One DDM is the Gordon Growth Model, which assumes a growth perpetuity: stock price = dividend / ( discount rate - constant dividend growth rate). By considering a company's dividend track record, Wall Street analysts can forecast future dividends and estimate a stock's fair value.
Imagine that a company's stock trades at $10 with a 5 percent dividend yield. Thus, every year investors receive $0.50 in dividend payments. Although the company has been growing, it has kept its dividend flat in order to reinvest its cash flows back into the business. A simple projection might be assume that the company sticks to its fixed dividend policy of $0.50. If the appropriate discount rate for the business is 8 percent, then the fair price of the stock is $6.25 (0.50 / 0.08 - 0).
Choosing which valuation model to apply is a case-by-case decision. Generally speaking, it's suitable to use the DCF model for companies that don't pay dividends or whose dividends are significantly higher or lower than their free cash flows. Conversely, the DDM can be used to value companies with reasonably predictable dividend policies whose dividends approximate their free cash flows. In addition, investors can take advantage of additional valuation techniques that involve little modeling, such as price-to-earnings multiples.
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