How to Value Dividend Stocks
Introduction
Even though dividend returns are the primary goal for dividend growth investors, the importance of buying dividend stocks at favourable valuations is still important.
Buying companies at a discount to their fair/intrinsic value:
- Increases higher total return potential
- Potential downside risk is reduced, increasing the likelihood of capital preservation in various market conditions
Valuation Methods and Ratios
1. Dividend Discount Model (DDM)
The Dividend Discount Model is a popular valuation method that calculates the present value of future dividends to determine a stock’s intrinsic value.
NB! We have a built-in Dividend Discount Model calculator on our Premium homepage that you can use, but I’ll give you an example on the science behind it.
Formula:
Intrinsic Value = (Dividends per share in Year 1) / (Discount Rate – Dividend Growth Rate)
Discount rate: The rate at which future cash flows/dividends are discounted back into present-day value. There are many different approaches to determining your discount rate, but the easiest way is to think of it as your required rate of yearly return.
Example:
- Dividends per share in Year 1: $2
- Discount Rate: 10%
- Dividend Growth Rate: 5%
Intrinsic Value = $2 / (0.10 – 0.05) = $40
2. Discounted Cash Flow Model (DCF)
The Discounted Cash Flow model is an advanced valuation method that calculates the present value of future cash flows generated by the company, including dividends.
Formula:
Intrinsic Value = ∑ (Free Cash Flow in Year n) / (1 + Discount Rate)^n
Discount rate: The rate at which future cash flows are discounted back into present-day value. There are many different approaches to determining your discount rate, but the easiest way is to think of it as your required rate of yearly return.
Example:
- Discount Rate: 10%
- Year 1 FCF: $1,000,000
- Year 2 FCF: $1,100,000
- Year 3 FCF: $1,200,000
Intrinsic Value = ($1,000,000 / (1 + 0.10)^1) + ($1,100,000 / (1 + 0.10)^2) + ($1,200,000 / (1 + 0.10)^3) = $2,683,073
Here at Dividend Athlete we like to use the 2-stage Discounted Cash Flow Model
The 2-Stage DCF Model
The two-stage DCF model considers two distinct phases of a company’s growth. The first stage assumes a faster free cash flow (FCF) growth rate for a specific number of years, while the second stage assumes a slower perpetuity growth rate thereafter. The sum of the present values of the FCFs in both stages represents the intrinsic value of the company.
NB! We have a built-in 2-Stage DCF Calculator on our Premium homepage that you can use, but I’ll give you an example on the science behind it.
For this example, let’s assume the following inputs:
- TechGains Corp currently generates $1,000,000 in FCF.
- The first-stage FCF growth rate is estimated at 10% for 10 years.
- The discount rate is 10%.
- The perpetuity FCF growth rate is estimated at 3% after 10 years.
- TechGains Corp has 1,000,000 outstanding shares.
Step 1: Calculate the FCF for each year in the first stage
First, we need to calculate the FCF for each year during the first stage:
Year 1 FCF: $1,000,000 * (1 + 10%) = $1,100,000 Year 2 FCF: $1,100,000 * (1 + 10%) = $1,210,000 … Year 10 FCF: $2,593,742 (calculated using the same formula)
Step 2: Discount the FCF for each year in the first stage
Next, we need to discount the FCF for each year using the discount rate (10%):
Year 1 PV (Present Value): $1,100,000 / (1 + 10%)^1 = $1,000,000 Year 2 PV: $1,210,000 / (1 + 10%)^2 = $1,000,000 … Year 10 PV: $2,593,742 / (1 + 10%)^10 = $1,000,000
Step 3: Calculate the terminal value
The terminal value represents the present value of all future cash flows beyond the first-stage period. It is calculated using the perpetuity growth rate (3%):
Terminal Value = (Year 10 FCF * (1 + perpetuity growth rate)) / (discount rate – perpetuity growth rate) Terminal Value = ($2,593,742 * (1 + 3%)) / (10% – 3%) = $38,081,313
Step 4: Discount the terminal value
Now, we need to discount the terminal value back to the present:
Discounted Terminal Value = $38,081,313 / (1 + 10%)^10 = $14,691,600
Step 5: Calculate the intrinsic value
Finally, we add up the discounted FCFs for the first 10 years and the discounted terminal value to calculate the intrinsic value of the company:
Intrinsic Value = Σ (Discounted FCFs for the first 10 years) + Discounted Terminal Value Intrinsic Value = $10,000,000 (sum of discounted FCFs for the first 10 years) + $14,691,600 Intrinsic Value = $24,691,600
Step 6: Calculate the per-share intrinsic value
To determine the per-share intrinsic value, divide the intrinsic value by the number of outstanding shares:
Per-Share Intrinsic Value = Intrinsic Value / Outstanding Shares Per-Share Intrinsic Value = $24,691,600 / 1,000,000 Per-Share Intrinsic Value = $24.69
According to the two-stage DCF model, the intrinsic value of TechGains Corp per share is $24.69. Investors can use this value to determine if the company’s stock is overvalued or undervalued and make informed investment decisions.
3. Price-to-Earnings Ratio (P/E)
The P/E ratio is a widely used valuation metric that compares a stock’s price to its earnings per share.
Formula:
P/E Ratio = Stock Price / Earnings per Share
Example:
- Stock Price: $50
- Earnings per Share: $5
P/E Ratio = $50 / $5 = 10
Important: The P/E ratio on its own doesn’t tell you much, it needs to be evaluated against the company’s own historical average, its peers and with the company’s other fundamentals taken into account.
4. Price-to-Free Cash Flow Ratio (P/FCF)
The P/FCF ratio is similar to the P/E ratio but uses a company’s free cash flow instead of earnings.
Formula:
P/FCF Ratio = Stock Price / Free Cash Flow per Share
Example:
- Stock Price: $50
- Free Cash Flow per Share: $4
P/FCF Ratio = $50 / $4 = 12.5
Important: The P/FCF ratio on its own doesn’t tell you much, it needs to be evaluated against the company’s own historical average, its peers and with the company’s other fundamentals taken into account.
5. CAPE Ratio (Cyclically Adjusted Price-to-Earnings Ratio)
The CAPE ratio adjusts the P/E ratio for inflation and business cycles, providing a more accurate valuation over longer periods.
Formula:
CAPE Ratio = Stock Price / (Average Inflation-Adjusted Earnings per Share over 10 years)
Example:
Let’s calculate the CAPE ratio for a hypothetical company, TechGains Corp, using the following data:
| Year | Inflation-Adjusted Earnings per Share (EPS) |
|---|---|
| 1 | $4.00 |
| 2 | $4.20 |
| 3 | $4.50 |
| 4 | $4.80 |
| 5 | $5.00 |
| 6 | $5.50 |
| 7 | $5.80 |
| 8 | $6.00 |
| 9 | $6.20 |
| 10 | $6.50 |
Current stock price: $100
To calculate the CAPE ratio for Company ABC, follow these steps:
Step 1: Calculate the 10-year average inflation-adjusted earnings per share (EPS) by adding the EPS values for each year and dividing the sum by 10:
Average EPS = ($4.00 + $4.20 + $4.50 + $4.80 + $5.00 + $5.50 + $5.80 + $6.00 + $6.20 + $6.50) / 10 Average EPS = $52.50 / 10 Average EPS = $5.25
Step 2: Divide the current stock price by the 10-year average EPS:
CAPE ratio = Current Stock Price / 10-year Average EPS CAPE ratio = $100 / $5.25
CAPE ratio = 19.05
6. Enterprise Value-to-Free Cash Flow Ratio (EV/FCF)
The EV/FCF ratio compares a company’s enterprise value to its free cash flow, providing a more comprehensive view of the company’s value.
Formula
EV/FCF Ratio = Enterprise Value / Free Cash Flow
EV = Market Capitalization + Market Value of Debt – Cash and Equivalents
Example:
- Market Capitalization: $500 million
- Total Debt (short-term and long-term): $300 million
- Cash and Cash Equivalents: $100 million
Plugging in the values we get:
EV = $500 million (Market Capitalization) + $300 million (Total Debt) – $100 million (Cash and Cash Equivalents)
EV = $700 million
EV/FCF Ratio = $700,000,000 / $100,000,000 = 7
Appropriate Situations for Each Valuation Method
- Dividend Discount Model (DDM): Suitable for stable, mature companies with consistent dividend growth (higher-yield, slow-growing companies with high payout ratios)
- Discounted Cash Flow Model (DCF): Suitable for companies that are re-investing a significant portion of cash flows as well as paying a dividend.
- Price-to-Earnings Ratio (P/E): Simplest metric, suitable for comparing companies in the same industry or with similar growth rates, also to compare with company’s own historical averages.
- Price-to-Free Cash Flow Ratio (P/FCF): Suitable for companies with volatile earnings, to be used for comparing companies in the same industry or with similar growth rates, also to compare with company’s own historical averages.
- CAPE Ratio: Suitable for cyclical companies to make sure smoothed-out earnings are used (top or bottom of the cycle earnings can distort the value proposition)
- Enterprise Value-to-Free Cash Flow Ratio (EV/FCF): Suitable if you want to take the company’s debt load into account as well
Valuing (dividend) stocks requires a thorough understanding of various valuation methods and ratios. By analyzing the appropriate metrics for each situation, investors can make informed decisions about the fair value of dividend stocks and maximize their total return potential over time.