Fundamental Valuation of Stock

Hey there,

The other day I wrote up a little bit about:

- The Dividend Discount Model,
- The Discounted Cash Flow Model, and
- The Residual Income Model

These models are often used by "fundamental" analysts to value stock, though the models actually give the same valuations with the same assumptions.

I thought some Sowpub readers may be interested in this, so thought I'd post a link! I'm open for questions or criticism. :)

http://www.stormcity.com/dcfvsrim.htm

Best Regards,

Thomas.




DDM vs DCF vs RIM

Thomas:

My question is not so much to do with the models as you presented them, but with the underlying formulas you used.

For instance:

In the discounted Cashflow Model you have
Cash Earnings: $1.70
Capital Exp: $0.50
FCF: $120 (which is obviously $170 - $0.50)

Then you have

Present Value of FCF: $1.09

How did you figure out the Present Value?

If I discount the $1.20 by 10% I get $1.08.

But if I use the same method used to calculate GST (Divide by 11) and take that number away from the $1.20, then I get $1.09 ($1.091 actually).

After that though, I have no idea how you are coming up with your Present Value FCF numbers.

For that matter, all your Present Value numbers are mysterious to me.

$15 future value is $9.31 ($9.32 in the other model).

How did you come up with that number - $9.31?

If I subtract 9.1% from $15, then 9.1% from that number, then 9.1% from that number, and so on for 5 years, I get $9.309165 ($9.31).

And I get 9.1% by using the GST calculation (Divide by 11) or in this case (1/11) x 100 = 9.1%

Is there some special calculator you are using to work this out? Or formula?

Michael Ross

Michael,

> Then you have
> Present Value of FCF: $1.09
> How did you figure out the Present Value?
> If I discount the $1.20 by 10% I get $1.08.

Often when working out present values you divide by one plus the interest rate to the power of the number of years.

So here the $1.09 is equal to $1.20 divided by 1.10.

If you were to go the other way, to compute future values, you would multiply by 1.10. That is, if you had a bank account with $1.09 in it and it paid 10% interest, you would have $1.20 at the end, calculated by multiplying $1.09 by 1.1.

> After that though, I have no idea how you
> are coming up with your Present Value FCF
> numbers.

> For that matter, all your Present Value
> numbers are mysterious to me.

So for example, in year 3 we have a FCF of $1.19. To get the present value, this is divided by 1.1 to the power of 3... Or (1 plus the interest rate) to the power of the years.

> $15 future value is $9.31 ($9.32 in the
> other model).

> How did you come up with that number -
> $9.31?

The Dividend Discount model gets $9.31 from taking the sale price of $15 and dividing it by (1.1 to the power of 5).

The discounted cash flow model gets a value of $9.32 in year 5, which is from $15 less $5.68 (the cash balance in year 5). The present value is then calculated as $5.79, or $9.32 divided by (1.1 to the power of 5).

> Is there some special calculator you are
> using to work this out? Or formula?

Nah, it's just about dividing rather than subtracting. :)

Best Regards,

Thomas.

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