How do you calculate the value of a stock?

[Robert_NL]

(12-01-2013, 11:32 AM)KenBob Wrote: Valuation is the main problem to solve with stock investing.

Essentially, there are three basic methods used by dividend investors: price to earnings ratio, average stock yield, and variations on a perpetuity calculation (such as the dividend growth model).

Price to earnings ratio (P/E) is very easy to apply. A stock is bought when the price to earnings ration is below a historic average. The average stock market P/E of 15 to 16 is used by many. The main issue with this technique is that some stocks trade at a premium to the stock market average, while others trade at a discount. Therefore, this method works best when you know that stocks historic average.

The average stock yield method is similar; however, the historic average yield for a stock is used.

I personally don't like the above two methods, since a database of historic averages is required and it really doesn't address the case where stock market or company conditions are not average.

I prefer to use a perpetuity method where the stock price is calculated by dividing the benefit by a discount rate. A perpetuity is a bond without a maturing date. For the basic perpetuity calculation, the periodic payments are divided by the perpetuity's interest rate.

The dividend growth model uses earnings as the benefit with the discount rate being the total return rate minus the dividend growth rate. The main problem with this model is that it is mathematically unstable. The total return rate is largely a guess and using the historic dividend growth rate can cause a negative price.

I prefer using the dividend as the benefit with the corporate bond index yield as the basis of the discount rate. The dividend can be adjusted to the average considering growth over a given period (I use 5 years). The current inflation rate is subtracted from the bond yield to get discount rate. Stocks should rise in value with inflation, while bonds have a fixed value, so inflation must be included in the yield. This provides a direct calculation of an income stock's value compared to its principle competitor, corporate bonds. It will not work with low yielding stocks.

As an additional warning. Stocks which have problems, such as high payout ratio and high debt, should be eliminated prior to performing the valuation calculation.

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A good reference to valuation is The Little Book of Valuation. It is written by a finance professor who specializes in valuation techniques. I think it is more relevant to a professional rather than an amateur; however, it is a good discussion of the principles.

Thanks for the reply. I only analyse companies with a p/e lower than 20 to exclude companies which have a high valuation. I have played with the dividend discount model, but I find it too picky and too sensitive for input. I think many companies would be overvalued when using dividend discount model.

I already read the book 'The little book of valuation', it was a nice read actually.

(12-01-2013, 06:48 PM)Kerim Wrote: This is such a good topic, and I've been planning to do some deep reading on valuation soon. It is of course the core issue for most investing decisions. Of course, that said, it is important to remember that there is not such a thing as the "right" value of a stock, as it includes many subjective components.

I know there is no right value, but I'm curious to know what other dividend growth investors use for calculating the fair value.

(12-01-2013, 10:43 PM)cannew Wrote: First, congratulations for recognizing at such an early age the importance of starting your investment for retirement. I certainly didn't even consider investing at such an early age.

Secondly, I believe you've hit on the right strategy, dividend growth investing.

What I would suggest is consider your investment options:

1. Can you take advantage of a company plan where they would match or contribute to your savings.
2. Can you buy stocks in a registered plan?
3. Have you considered Company DRIP's and those which will allow you to invest additional funds at no cost?

As for how to calculate the value of a stock, I've given up on many of the standard methods and prefer to stick to Dividend Yield (after I've selected a list of stocks I want to follow). I look at the company's long term average yield (say 10 yrs) and try to only buy when the current yield is higher than the average.

From your readings (and those mentioned on this site) you can easily identify 10 to 20 stocks which will be great DG stocks to buy. Check the dividend history (min 10 yrs, prefer longer than 25) and dividend growth history. Avoid cyclical stocks.

I also maintain a buy price for each stock on my list which usually is less than my current average cost of the stock and offers a higher yield than the long term average.

At your age I would re-invest the dividends and add to my positions regularly. Don't look to sell to take profits. If you have limited funds than don't spread yourself over a large number of stocks, find 10 to 15 good DG stocks and ignore all the rest. Buying and selling will cost you in the long run.

Also thanks for the reply!

Because I'm so young I hope I can retire early, although I don't earn much so the monthly investing budget is way too low to retire before 50 I think.

I cannot take part in a company plan as we in Europe (that's were I live) don't have that. I actually don't know what you mean with a registered plan. Dripping would be nice, but very difficult in Europe so currently I collect the dividends and reinvest them with additional capital.

Historic dividend yield is nice, but too limited I think.

I do not sell my stocks, only when they cut or freeze the dividend or the fundamentals change for the worst. I plan to hold to my stocks until I die.