Calculate fair value of any stock
Multi-Stage DDM Calculator for Stock’s Fair Value
The Dividend Discount Model (DDM) is a method that calculates a company’s stock price based on the sum of all future dividend payments from that company. The dividend sum is discounted back to its present value at a fair rate (discount rate or cost of equity or required rate of return).
Cost of Equity or Require rate of return is a more formal name for Discount Rate. The discount rate factors in the time value of money risk and the loss of investment capital risk. You should use a higher discount rate for riskier investments as a rule of thumb. It is important to use an appropriate discount rate to calculate a stock’s fair value using the Dividend Discount Model.
Let’s give a simple example. You lend your friend 100 USD and your friend returned you the borrowed 100 USD back after 1 year. You may think that you got your money back but in reality, you lost some money. The purchasing power of 100 USD next year is not the same as it is this year. Because of inflation, you will not be able to buy the same amount of goods and services. If the inflation is 10% then your friend should return you 110 USD. The present value of 110 USD is 100 USD this year if the inflation rate is 10%.
The same principle is applied in the Dividend Discount Model. The discount rate functions like the inflation rate. Based on holding time and dividend growth rate we can define few variations of DDM as follows:
Zero-Growth DDM
Zero-Growth DDM deals with the scenario when a stock pays the same dividend amount forever in perpetuity. You can calculate the current intrinsic value of that stock using the following simple formula:
P0=D/r
P0= Calculated Intrinsic Value of the stock at present time
D= Annual Dividend Payment
r = Discount Rate
Gordon Growth Model (GGM)
Gordon Growth Mode tackles the scenario when a stock shall pay a dividend forever that shall grow at a constant rate forever. You can calculate the current intrinsic value of that stock using the following formula:
P0=D1/(r-g)
P0= Calculated Intrinsic Value of the stock at present time
D1= Next year’s annual Dividend payment
r = Discount Rate
g = the constant dividend growth rate of the stock
Sometimes, it might be difficult to find the next year’s declared dividend. If you can find only this year’s dividend then you can use the following formula for constant growth DDM:
P0=(D0*(1+g))/(r-g)
P0= Calculated Intrinsic Value of the stock at present time
D0= This year’s annual Dividend payment
r = Discount Rate
g = the constant dividend growth rate of the stock
Variable Growth Multi-stage DDM
Constant rate Multi-period DDM deals with the scenario when you buy stock this year and plan to sell that stock 2 or more years later, and during this whole multi-period duration, the dividend payment from this stock had a variable growth rate.
How do we calculate the Discount Rate or Cost of Equity?
Discount Rate=Risk Free Rate+Beta∗(Market′s Annual Return–Risk Free Rate)
Beta is the volatility of the stock. You can find beta for each stock at morningstar.com
Risk-Free Rate is the interest/return an investor should get for zero-risk investments. Government’s long term (i.e. 10Y) treasury bond yield is considered as lowest risk. USA Risk-free rate at FRED Website (https://fred.stlouisfed.org/series/DGS10)
Market’s Annual Return is the average annualised historical retrun of the stock market. Long term (20-30Y) USA stock market returns around 10%, US Historical Market Return (https://www.macrotrends.net/2526/sp-500-historical-annual-returns)
Discounted Cash-flow (DCF) Calculator
Discounted Cash-flow Model is a quantitative method that calculates a company’s stock price based on the sum of all future free cash flow earned from that company at a discount rate. This discount rate factors in time and risk. Let’s say you lend your friend 100 USD and the friend returned you 100 USD back after 5 years. The value of 100 after 5 years is not the same as it is today. Your 100 could earn you interest. That is why future earnings need to be discounted to determine the fair value at the present day.
Peter Lynch’s Fair Value Formula
Peter Lynch’s Fair value is based on the PEGY ratio. He inverted the PEGY ratio to make the valuation of a stock. Based on the value of Lynch’s Fair Value ratio, he determines the valuation of the stock. Below is Peter Lynch’s Fair Value Formula, you can find it in his book “One up on Wall Street”, page 199.
Peter Lynch′s Fair Value=(Earnings Growth Rate+Dividend Yield):(P/E)
If a company’s growth rate (including dividend yield) is equal to its Price-to-Earning ratio, Lynch’s fair value ratio will be equal to 1. According to Peter Lynch, Ratio value = 1 means that the stock is trading at a fair valuation. If the value is less than 1, the stock is over-valued. If the value is equal to 2, the stock is under-valued. If the value is equal to 2, the stock is under-valued. If the value is more than 3, the stock is very under-valued.
What do the parameters of Peter Lynch’s Fair Value Represent?
Earnings Growths Rate: Use the estimated future long term growth. You can take an average of the next 3-5 years Earnings-per-share (EPS) growth rate. You can use the last 5-10 years’ average earnings growth rate If you can not find a good future estimate.
Dividend Yield: Use the latest dividend yield. Divide the latest annual cash dividend per share by the share price and you will the dividend yield.
Price-to-Earning (P/E): Divide the stock price by EPS and you will get the P/E ratio.
Peter Lynch Fair Value formula is based on the Dividend Adjusted PEG ratio. Another name for the Dividend Adjusted PEG ratio is the PEGY Ratio.
PEGY Ratio= (P/E):(Earnings Growth Rate+Dividend Yield)
Stock’s fair value calculations examples using Peter Lynch’s Method?
Lynch’s Ratio=(EPS Growth+Dividend Yield)/(Tailing P/E)
High growth company’s valuation using Peter Lynch’s Method:
Facebook: Lynch’s Ratio=(28.6+0)/28.01=1.02 (Fairly-Valued).
Google: Lynch’s Ratio=(24.41+0)/31.4=0.78 (Over-Valued).
Microsoft: Lynch’s Ratio=(15.25+0.75)/37.11=0.43 (Very Over-Valued).
Amazon: Lynch’s Ratio=(35.77+0)/61.15=0.58 (Over-Valued).
Low growth company’s valuation using Peter Lynch’s Method:
JnJ: Lynch’s Ratio=(8.89+2.46)/25.83=0.44 (Very Over-Valued).
Altria: Lynch’s Ratio=(4.67+7.09)/20.67=0.57 (Over-Valued).
AT&T: Lynch’s Ratio=(2.7+7.55)/8.51=1.2 (Fairly-Valued).
Merck & Company: Lynch’s Ratio=(12.77+3.42)/13.17=1.23 (Fairly-Valued).
Peter Lynch’s fair value calculation is a very quick and easy way to do a stock valuation. It is a very powerful method as any beginner can use it. It has some limitations: does not calculate an exact intrinsic value, the broader fundamentals of a business are not under consideration, and tends to underestimate slow growing companies
Benjamin Graham’s Number calculator for stock’s fair value
Graham’s Number is the maximum price so, anything above the calculated value is overpriced for that stock. The formula that derives the Benjamin Graham’s Number is as follows:
Graham Number=√(15∗1.5∗EPS∗BVPS)
What do the parameters of Graham’s Number represent?
15: This parameter represents the maximum value of the Price-to-Earning (P/E) ratio an investor should pay for a stock.
1.5: This parameter represents the maximum multiple of the Price-to-Book (P/B) ratio an investor should pay for a stock.
EPS: Divide the net earnings by the total number of outstanding shares, you will get Earnings Per Share (EPS). EPS=Net Earning/Total Shares Outstanding.
BVPS: Subtract total liabilities from the total assets of a company to calculate the company’s Book Value (BV). Divide BV by the total number of shares outstanding to find out the Book Value Per Share (BVPS) of a company. BVPS=(Total Asets-Total Liabilities)/Total Shares Outstanding.
How to customize the parameters of Benjamin Graham’s Number?
Graham used 15 as the maximum P/E and 1.5 as the maximum P/B. If you don’t know a better assumption to use then use what Graham used. You can customize Benjamin Graham’s Number formula using one of the two following methods: Industry Mean and Stock’s long-term Mean.
Use Sector/Industry
Median Every industry is different. Industries like high growth tend to trade at a high multiple of P/E and P/B primarily because growth companies burn through a lot of earning and/or take debt to grow. Maximum P/E = 15 and Maximum P/B = 1.5 is not always justified for all industries. You can take the long term mean or median of the industry and use that as the Maximum P/E and/or P/B. The industry Mean could be higher or lower than what Graham used in his Number Formula
Use Stock’s long-term (5-10 years)
Mean Everything has a tendency to revert to mean. You can use that method to set the Maximum P/E or P/B value in Graham’s Number Formula. Calculate the stock’s long-term (i.e. 10-15 years) mean of P/E and P/B and use that value instead of P/E=15 and P/B = 1.5. If you use this method you are using a different value for each stock.
Stock’s fair value calculations examples using Graham’s Number
Valuation using Sector Median in Graham’s Number: Graham Number=√(SectorP/E∗SectorP/B∗EPS∗BVPS).
You can customize the Graham Number by using industry-specific P/E and P/B. Let’s apply Sector Median P/E and P/B as the maximum P/E and maximum P/B in Graham’s Number.
Facebook: Graham Number=√(21.88∗2.6∗13.58∗49.03)=194.6 USD.
Google: Graham Number=√(21.88∗2.6∗92.15∗683)=1892.2 USD.
AT&T: Graham Number=√(21.88∗2.6∗(-0.31)∗22.73)=NA.
Alibaba: Graham Number=√(15.64∗3.01∗8.33∗55.6)=147.6 USD.
JnJ: Graham Number=√(36.01∗3.79∗6.65∗26.43)=154.9 USD.
Bank of America: Graham Number=√(10.75∗1.17∗3∗30.15)=33.7 USD.
Benjamin Graham’s Number is a very powerful method to calculate the maximum price of a stock because it is easy for beginners to use. It has some limitations are: use the same value of parameters for every industry, can not calculate intrinsic value if Earnings Per Share is negative, tends to underestimate the high growth stocks, and do not take the business broader business fundamentals.
