| It's important to pay
the right price for the stocks you purchase. The most popular stock valuation model is the
multiple-growth general dividend discount model. The dividend valuation model allows
investors to assess the fair value of a stock that pays dividends at various rates.
Another approach is to estimate the stock's earnings per share over a period of time to
determine the fair value of the stock. That is, calculate the stock's "normal"
price earnings ratio. Using the example
below the "normal" price earnings ratio is 18.4997. To determine the fair value
of the stock multiply the "normal" price earnings ratio times the current
annual dividend amount. In the example below, the "normal" price earnings ratio
is 18.4997 X $6.00 for a fair value of $110.9982. In other words, $110 is the current fair
market value of the stock.
The fair value amount of $110 is then compared to
the current sales price, of say $109. The difference between the two stock prices is
$1.9982. This analysis indicates that the stock is selling close to the "normal"
price earnings ratio and can be viewed as fairly valued.
The Price Earnings Model Formula
V/Eo = [p1(1+ge1)/(1 +k)] + [p2(1+p1)(1+ge2)/(1+k)(1+k)] + {p3(1+p1)(1+ge2)(1+ge3)/(k-g)[(1+k)(1+k)]}
Example Legend
V/Eo = Represents what the price earnings ratio should be if the stock were fairly priced
d1 = Expected dividend for 2000 = $6.50
d2 = Expected dividend for 2001 = $7.26
d3 = Expected dividend for 2002 = 7.99
ge1 = Expected growth rate of earnings for 2000 = .15
ge2 = Expected growth rate of earnings for 2001 = .10
ge3 = Expected growth rate of earnings for 2002 = .10
p1 = Estimated payout projected for 2000 = .56
p2 = Estimated payout projected for 2001 = .60 (rounded)
p3 = Estimated payout projected for 2002 = .60 (rounded)
g = Expected growth rate = .10
k = Investors required rate of return = .15
do = Current dividend = $6.00
Therefore
V/Eo = [p1(1+ge1)/(1 +k)] + [p2(1+p1)(1+ge2)/(1+k)(1+k)] + {p3(1+p1)(1+ge2)(1+ge3)/(k-g)[(1+k)(1+k)]}
V/Eo = [.56(1 + .15) / (1 + .15)] + [.60(1 + .56)(1 + .10) / (1 + .15)(1 + .15)] + {.60(1 + .56)(1 + .10)(1+.10) / (.15-.10)[(1+.15)(1+.15)]}
V/Eo = .644/1.15 + 1.03 /1.322 + 1.1326/ .066
V/Eo = Price earnings ratio if fairly valued = .5600 + .7791 + 17.1606 = 18.4997
Fair Value Formula
Fair Value = V/Eo X do
Fair Value = Price Earnings Ratio if Fairly Valued times Current Dividend
Fair Value = 18.4997 X $6.00 = $110.998
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