Stock valuation is the process of determining intrinsic or fair value of common stock.
In theory, the Intrinsic value of common stock is the sum of the present values of all future cash flows associated with the common stock investment, discounted at shareholders required rate of return.
The expected cash flow from stocks is difficult to predict in advance.
For that reason, let me tell you out right, stock valuation is difficult.
Dividend Discount Model
One of the most popular model to determine common stock value is the dividend discount model.
In this model, future streams of expected dividends are used as the basic input for common stock valuation.
Investors, who purchased common stock receives dividend during the holding period and also realize proceeds from sale of stock at the end of the period.
Thus, the value of common stock, in this case, is the sum of the present value of future dividend payments plus
Therefore, this model is limited to those companies only who pay dividends.
P = D0 + D1 + D2 + D3 + … + Dn + Pn
P = Intrinsic value
D0 = Current Dividend
D1 = Current value of next year Dividend
Pn = Stock price at the end of the investment period
The discount rate used in this model is a dark black box. None seems to have a better gauge about it and I am no exception.
All of the variables in the above equation are the prediction of the future, which I am not quite fond of. Despite the popularity of the dividend discount model, I believe, it is not sensible to expect the correct result when all of your variables are prediction.
Albeit, I must agree that investors who actually follow this model do better than the investors who don’t follow any model at all.