How to Value a Share of Stock for Investment Banking
Investment banking analysts use variations of the free cash flow model to value entire firms. These models are the basis for suggesting potential actions — like mergers and acquisitions and stock repurchases — to increase the value of the firm. However, another very common variation of these discounted cash flow models involves valuing the common stock of a firm and forms the basis for making buy and sell recommendations to clients.
Similar to valuing an entire firm, the value of a share of stock should be equal to the cash flows received by the owner of that stock. The ultimate owner of a share of stock receives dividends from the firm and that’s it.
Sure, most investors buy stock because they believe it’ll go up in value and they’ll be able to sell it for more than they bought it for, but the only cash flow received by the owner of a share of stock is dividends. So, the value of a share of stock is equal to the present value of all expected dividends from owing that share of stock.
The discount rate used to discount those cash flows to a present value is the required return on equity discussed earlier and is most often computed by using the CAPM. The equation for the value of a share of stock is:
where Dn is the dividend at year n and re is the required return on equity.
It appears that you have a daunting task because you have to solve an equation with an infinite number of terms. But, as before, if you make the simplifying assumption that dividends are going to grow at a constant rate forever, the formula reduces to a very simple form:
So, to value a share of stock assuming a constant growth rate in dividends, all you need to do is look up the current annual dividend, and come up with estimates of that growth rate and an estimated required return on equity.
You can use publicly available data to apply this formula and value a share of stock of Occidental Petroleum (ticker symbol: OXY). According to Thomson Reuters, the consensus estimate long-term earnings growth rate for Occidental Petroleum of the analysts who cover the stock is 5.38 percent.
You can use this earnings growth rate as a proxy for dividend growth because, in the long run, the two growth rates tend to be very similar for established firms. Occidental Petroleum’s beta as computed by Thomson Reuters is 1.22. So, to value a share of OXY stock, you simply need to compute the required return on equity for OXY. Using the CAPM, OXY’s required return on equity is:
Required Return on OXY Stock = rf + β(Market Risk Premium) = 0.03 + 1.22 × (8.15) = 9.97%
Therefore, the value of a share of OXY stock is estimated to be:
According to this simple analysis, a share of OXY stock would be worth $58.77. Currently, a share was selling for nearly $90 per share, so our analysis would imply that the shares are overvalued by a substantial amount — approximately $30 per share.
Does this mean you should all run out and sell our shares of OXY and perhaps even short-sell the shares? The answer is no. You would need to more carefully evaluate our assumptions and determine how realistic these inputs are.
For example, the consensus growth estimate provided by Thomson Reuters has a very small sample size of only four analysts. In fact, one analyst estimated the growth rate to be 8 percent. With an 8 percent growth rate and a required rate of return of 9.97 percent, the shares would be estimated to be worth over $140 each.
Another analyst estimated the growth rate to be a paltry 2.6 percent. This would imply a value of $35.64. This simple analysis illustrates why some investors are buying OXY at the market clearing price and other investors are selling the stock at that same price. They have different expectations for future cash flows from the firm.