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The Best Way to Value a Stock: Part I

Seasoned investors will probably agree with me that valuing a stock is one of the most challenging aspects of investing. Even professional analysts often disagree on the exact value of a company. This is partially because of the overwhelming number of valuation techniques that we can choose from. Using a different valuation technique can lead to very different conclusions on what a company is worth.

So, the question is, which valuation technique should we use? Unfortunately, the simple answer is that there is no one-size-fits-all valuation technique. Each stock calls for its unique way of calculating its fair value. With that, I will take a look at two commonly used valuation techniques and when is the best time use them.

Discounted cash flow model (DCF)

The discounted cash flow model or DCF model is meant to estimate the value of a company by taking into account the forecasted free cash flows that the company will generate in the next five to ten years. This method was popularised by Warren Buffett who strongly believes that a company’s intrinsic value is based on the amount of cash it can generate in the future. For a detailed analysis of the DCF model, you may wish to take a look at this earlier article.

Besides cash flow, this method also takes into account the time value of money as cash on hand now is more valuable than cash in the future. However, as you may have guessed, there are certain limitations to using this model to value a company.

First, the DCF model requires an investor to accurately predict the future cash flows of the company, which in reality is not so simple. Second, the discount value of money will also need to be estimated. Different discount values will lead to a very different valuation of the future cash flows, and consequently, a different value on the company.

Therefore, the best companies to use the DCF model on are companies that have a predictable and steady free cash flow generation. These are usually mature companies that have a wide array of businesses, rendering them immune to economic cycles.

On the contrary, we should not attempt to use the DCF model to value companies that have negative free cash flow or are cyclical in nature as estimations for these companies will often be off the mark.

Dividend discount model (DDM)

The dividend discount model or DDM calculates the value of the company based on future dividends paid out to shareholders. By using this method, we assume that the value of a company is dependent on dividends as it represents the true cash flow received by shareholders. By calculating the present value of the dividend cash flow, we can get an idea of the worth of a company.

Once again, there are loopholes to this method. One downside is that this method requires us to estimate future dividend payout over a period of five to ten years. For many companies, this is almost impossible. Companies may face unforeseen business headwinds or may change their dividend payout ratio, leading to more or lesser dividends.

Therefore, as with the DCF model, the DDM model should only be used for mature companies with steady and sustainable dividend policies. These include companies that have been paying dividends for many years, and have a long and excellent history of sustainable profits.

The Foolish bottom line

Valuation techniques each have their own unique proposition and advantage. It is important that investors make use of each method in the correct scenario to help give a better reflection of the company’s worth. In the next article, I will take a look at two more valuation techniques and point to the type of firms that we should use those on.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice.