Valuation lies at the heart of dividend-growth investing… Learn how you can effectively and efficiently value stocks and easily identify value opportunities!
One of the challenges retail dividend-growth and value investors face is how to value a company. It can be a daunting subject to study and even harder to implement—but it lies at the very heart of our investing approach. Ultimately, if we are going to find success, we must be able to effectively and efficiently identify value opportunities—enabling us to capitalize on them.
To overcome this challenge, I recommend (and use) the discounted earnings model (DEM) to quickly and effectively value stocks. You can set up your own DEM calculator in just four simple steps with Excel and greatly improve your ability to identify value opportunities.
Simply put, valuation is the process of determining the value of an asset or company. From a dividend-growth or value-investing point of view, we want to determine the fair value of company—meaning what we believe it is actually worth. We can than compare this to the current market value and determine if the company is undervalued or overvalued.
In a broad sense, there are two approaches to generating a valuation: absolute valuation and relative valuation.
The absolute valuation method seeks to calculate a valuation be looking inside of the company. This approach uses fundamental analysis, including data such as dividends, cash flow, and growth rates. Examples of absolute valuation methods include the dividend discount model (DDM), discounted cash flow model (DCF), discounted earnings model (DEM), residual income model (RIM), and the capital asset pricing model (CAPM).
In this article, we will explore the discounted earnings model (DEM), which is a simplified variation of the DCF model.
In stark contrast to absolute valuation approaches, relative valuation methods seek to calculate valuation by looking outside of the company by comparing it to other similar companies—typically through the use of ratios. For example, if a company has a low price-to-earnings (PE) ratio relative to another similar company, then one possible conclusion is that it is relatively undervalued.
Another great metric for relative valuation is yield. For a great look at how you can incorporate relative-yield analysis into your investing, I encourage you to read my article Dividend Yield: What Every Dividend Growth Investor Needs to Know!
Though less precise, relative valuation is simpler and quicker to perform than absolute valuation. Therefore, it is often a good starting point to identify potential values—before investing the time and energy into an absolute valuation deep-dive analysis.
It is worth noting that even “absolute” valuation methods often involve assumptions that are relative in nature. For example, in determining terminal values, a PE ratio can be utilized—and selecting one is predicated on a relative determination (both internally and externally).
Obviously, you can value stocks just like you would any other income-producing asset. After all, stock represents fractional ownership of an income-producing business.
So, to borrow from Joel Greenblatt, valuing a company should be no different from valuing a house. If you were interested in purchasing a house offered at $400k, how would value it?
First, you could look at the present value of future cash flows that you could earn from renting it. This is known as the discounted cash flow (DCF) method and is an example of absolute valuation.
Next, you could compare the list price against similar houses in the area. This would provide you with a relative (or “comp”arable) valuation. Obviously, this would be a form of relative valuation.
Finally, you could compare the current price against its historical range. This would provide you with another relative valuation indicator.
This is precisely how I value dividend-growth stocks. It is critically important to incorporate all three approaches (viz., absolute, relative to others, and relative to itself). For example, relative value means nothing if the entire group or class is overvalued—you would only identify the least overvalued option.
This is akin to buying the cheapest internet stock at the height of the dot-com bubble! No Bueno!
Here’s Greenblatt’s view on valuation from a talk he gave at Google (the above illustration begins at 7:00, but the whole talk is worth the listen):
When I’m valuating a potential stock, I start by calculating an absolute valuation using a discounted method—typically the discounted earnings method (DEM). This provides me with a baseline, fair-value target. I can compare this target to the current market value to determine how much potential value (if any) exists with the stock.
Note: I always conduct my valuation first—before looking at the current market price. If you look at the price first, it can influence your valuation process and critical assumptions.
Next, I utilize the PE ratio to perform two relative valuations. First, I compare the company’s PE to its historical range and average. Second, I compare it to the PEs of similar companies, as well as the industry average.
Finally, I analyze the stock’s yield—determining where it currently lies relative to its historical range.
This cohesive and comprehensive valuation approach provides me with a solid, actionable indication of whether the company is currently under or overvalued. I look for a market price that trades at a discount based on all three metrics.
Note: My valuation process is always subsequently filtered by a thorough fundamental analysis. This enables me to identify value multipliers (e.g., moats) and avoid value traps (i.e., bad companies). We want to identify quality companies at a bargain price—not junk!
The intrinsic value of junk will always continue to deteriorate over time—bad for long-term dividend-growth investors.
To paraphrase Buffett, time is the friend of quality companies and the enemy of junk—no matter how cheap that junk may be!
It is important to understand that value is not always recognized quickly by the market. It provides investors with an edge (a value discount); however, it may take time for that edge to produce results. If you do a solid job of valuing a company and recognizing value, then the market will likely recognize it as well… but that could be one year from now, three years from now, or even more.
As I always stress, “time in” the markets is much more important for the dividend-growth investor than “timing” the markets.
Thus, value investing is a long-run approach that requires patience and conviction. You are typically buying when others are running for the exits and you are typically buying companies that are currently disliked by or out-of-favor with the market. It’s a contrarian, blood-in-the-streets approach that takes time to capitalize on.
Valuating companies can be as complex or as simple as you want. Professional analysts often take it to the extremes of complexity. I prefer keeping it simple. I don’t need to get the valuation perfect—I’m just looking for an undervalued “zone” that (a) provides me with a margin of safety and (b) where I can begin to average into a position.
I’m NOT trying to nail the bottom and I also tend to build positions slowly. Thus, I don’t need to be precise—just in the ballpark.
I started off using (an arguably overcomplicated) discounted cash flow method. However, because I (a) eventually realized the salient points above and (b) recognized that the minimal gain in effectiveness (or accuracy) that I achieved using this approach did not offset the much larger loss in efficiency it created, I transitioned to a much simpler discounted earnings (DEM) approach—a method we will explore in the remainder of the article.
As dividend-growth investors, we need to understand that we are not primarily value investors in the sense that we are not focused on capital appreciation (it’s merely a perk). Rather, we are buy-and-hold, passive-income builders—not stock flippers.
We seek value opportunities because (1) they represent an empirically-supported factor (one that is favorable to dividend growth) and (2) they allow us to lock-in better yields—increasing our long-run yield-on-cost (YOC).
An important corollary to this is that valuation alone is of little use to us. We must always consider the other critical factor of quality and employ a thorough fundamental analysis of the company. Because we are in this for the long-run (not a short-run capital gain flip), the long-run performance and dividend growth of the company is vitally important to us. We must make every effort to filter out value traps and short-run opportunities with low-quality companies.
For more information on how I integrate factor investing into my dividend-growth investing, I highly recommend reading my article Does Size Matter When It Comes to Dividend Growth Investing?
All discounted valuation models work the same way: you sum (net) the present value of future cash flows.
What differentiates them is what types of cash flows you are discounting. Generally speaking, there are three (3) common choices: dividends, cash flow, or earnings (typically earnings-per-share or EPS).
The underlying premise is that a dollar today is worth more than a dollar tomorrow—also known as the time value of money. For example, if I invest a dollar today at 10%, then in one year, I’ll have $1.10. If this is true (and it is), then $1.10 a year from now is only worth $1 today—less.
This is how discounting works and the amount of that discount is dependent on the rate of return you can earn.
Let’s take a look at each of the three options…
The discounted dividend model (DDM) is the simplest and most rudimentary of the discounting methods.
To utilize this valuation method, you simply calculate the net present value of future dividend payments.
However, there are several issues with using this method. Chief among these is the fact that dividend payments are optional (determined by the board) and variable. As such, it is difficult to accurately establish a dividend growth rate over longer periods of time.
The dividend growth rate is a massive assumption with limited data to base it on. Furthermore, the assumed rate has an immense impact on the resulting valuation. Stated differently, a DDM valuation is highly-sensitive to the dividend growth rate you utilize—and the rate you select is a highly-subjective assumption.
For this reason, I find that it does not provide me with accurate, reliable, and actionable valuations. Worse, because it is so subjective, it fails to yield repeatable results as well.
The discounted cash flow (DCF) model is the standard for most professional analysts. This method calculates the net present value of future cash flow or cash flow from operations (CFO).
To determine this cash flow, analysts build complex, predictive financial statements. It is a labor-intensive and time-intensive activity. To reduce this cost, retail investors can streamline the process by simply utilizing estimated growth rates to predict future cash flows. While this makes the process more efficient, it does sacrifice the very detail that makes this model the professional standard.
However, as we noted earlier, sacrificing a little bit of accuracy to gain a significant amount of efficiency is a preferable option for retail investors—especially given that we don’t need super precise valuations.
Having said that, if we are going to streamline the system, why not maximize our opportunity? Let’s take a look at option number three…
The discounted earnings method (DEM) is my preferred model for generating company valuations. It accomplishes the same thing as the DCF, while simplifying things a bit more—maximizing efficiency with a minimal decrease in effectiveness.
Rather than focusing on cash flow, this method skips directly to discounting earnings-per-share (EPS). This factors in all potential dividends—making it a better choice than a pure DDM. Furthermore, because EPS data and estimates are readily available, it is easy and much faster to use than a pure DCF model.
Finally, the discounted earnings model (1) reduces the number of assumptions you need to make and (2) involves assumptions that are less subjective—increasing the accuracy, reliability, and repeatability of your valuations, which results in more actionable valuations.
Generating valuations with the discounted earnings method (DEM) is much easier than you may be thinking!
I could give you all the mathematical formulas and equations but, let’s face it, everyone uses Excel today. So, we’ll walk through the steps to calculating a DEM valuation using Excel formulas.
We’ll break the process into two fundamental components: Basic Assumptions and Valuation Steps.
In order to calculate a valuation using the discounted earnings method, there are a few assumptions we need to make in order to select some required values—three to be exact:
The first assumption we need to make is what the EPS growth rate will be for the company. The process of determining this can be as elaborate or as simple as you want to get. But remember, you want to be able to repeat this valuation process for multiple companies… so I recommend keeping it reasonably simple.
I like to look at the past four years of EPS growth and two years of future EPS growth (based on analyst estimates) to form my growth rate assumptions. You can be aggressive or conservative in your approach. I typically split the difference and look for a mean.
I’ll discuss my specific approach at the end of the article; however, for now, it’s sufficive to settle on one growth rate assumption for the next 10 years.
The second assumption we will need to make is what return we want to make on the investment over time.
Remember, in order to determine the time value of money, we need to know what rate of return we could make over a given period of time—or, in this case, the rate we want to make.
The higher the rate of return you select, the bigger your safety margin will be with the valuation. However, the greater the safety margin, the fewer the opportunities. It’s a balancing act—one predicated on your unique investing goals and risk tolerance/profile.
I typically shoot for a 10-15% required rate of return—10% being more aggressive and 15% being more conservative.
Finally, the third assumption we need to make is what the company’s long-term PE will be.
We will need to calculate a terminal value (covered in the next section). To do this, we will utilize a price-to-earnings (PE) value. This requires us to select a long-run PE that we think the company will average.
I like to take a relative approach to this and typically look at the company’s current PE, the company’s 5-year average PE, the industry’s average PE, and the broader PE average of the S&P (applying decreasing weighting in that order).
Now that we have our assumptions made, we can transition to actually calculating our DEM valuations.
To do this, we are going to utilize three things:
This valuation process involves four simple steps:
The first step is calculating our EPS values for years one through ten.
First, we need to set-up our basic Excel spreadsheet to look like this:
Note, the year for your first column (highlighted orange) should be the current fiscal year for your company. Additionally, you can use formulas to adjust the other years based on the first year you input:
Next, we need to enter our assumptions and the current year’s EPS:
Finally, we need to setup our formulas to calculate our EPS for each year based on our growth rate. Here are the formulas and the results:
The second step is calculating our terminal EPS value.
Remember, we are going to base this on our assumed terminal PE. This ratio tells us that if we multiply the price by the PE ratio, we will calculate the sum of all future EPS.
Thus, we are simply going to multiply the EPS in our 10th year (2029 in this case) by our terminal PE:
Step three is to calculate the present value of each future year’s EPS (and the terminal EPS value).
Excel makes this easy by providing us with a present value (PV) formula:
“rate” will equal our required rate of return.
“nper” will equal the period (i.e., year 1, 2, 3, etc.)
“pmt” will equal zero in this case
“fv” (or future value) will equal that year’s EPS (negative value)
First, we need to add numbers for each year. We will assume the current year to be zero (no time value of money impact). However, you can choose to set the current year to 1 if it is early in the fiscal year and you want to model a one-year present value impact for those earnings.
Next, we need to enter the present value formula for each year:
The final step is to simply add all the present values together to arrive at our valuation for the company.
Additionally, we can add the current market price and then calculate whether the stock is trading at a discount (undervalued) or a premium (overvalued).
In this case, with a market price of $24.96 and our valuation (fair value) of $21.80, the stock is overvalued and trading at a 14.5% premium.
Here’s what the whole calculator looks like when complete:
As I eluded to earlier, I do add a few bells and whistles to my own DEM valuation approach. Again, you can get as complex and detailed as you like. I feel my tweaks work well for me—providing added control and flexibility, while not sacrificing a lot of additional time and energy.
I like to calculate compound annual growth rates (CAGRs) when I’m selecting my EPS growth rate—both historical and available forward-looking estimates.
Additionally, I like to use several different EPS growth rates to increase the control and flexibility of my model. I use the mean EPS estimates for the first two years. Next, I use a short-term growth rate for years 3-6 and a mid-term growth rate for years 7-10.
I also select a long-term growth (LTG) rate for use with my terminal value (described next).
I like to have a check against my PE-based terminal value.
Over long periods of time, companies will mature, and their growth will decline—eventually mirroring that of the broader economy on average. We know that the economy has a historical growth average of roughly 3 percent.
Thus, I calculate a secondary present value for my terminal value based on a long-term growth rate.
You can choose whatever rate you want; however, I rarely ever exceed 3.5%. The lower you go, the more margin of safety you will have in your valuation… but the less likely the market price will hit your target (buying opportunity).
I typically opt for 2.0% to 3% (unless I have a fundamental reason to go lower or exceed the economy’s historical long-run growth rate).
Again, I use this to calculate a secondary present value for the terminal value. I can then compare this against the PE-generated value. In general, I do not like to exceed the secondary check value. If my PE-generated value is higher, I typically adjust the PE downward. This builds in an additional layer of safety.
However, this is entirely optional. If you are confident in your long-term PE value, you can stick with it—you’ll just have a higher valuation (fair value) for the company (and a lower margin of safety).
Here are screenshots of the DEM valuation calculator I currently use. I use three tabs: basic data entry, my assumptions, and my valuation calculations:
UPDATE: Here’s a great video from Michael Jay that he recently shared–it demonstrates some of the additional bells & whistles discussed above that you can integrate into your own DCF model…
The sky is the limit when it comes to valuating stocks. It is both an art (filled with a cornucopia of assumptions) and a science (replete with a slew of formulas, methods, and models).
Just like there’s no perfect boat—there’s no perfect valuation. It’s a balance of effectiveness vs. efficiency. Luckily for the retail dividend-growth investor, we don’t need a perfect solution—we just need to be the ballpark.
I encourage you to find your own valuation path. Incorporate what I’ve shared into it… but don’t limit yourself by it. We each need to find the right balance between absolute methods, relative methods, and solid fundamental analysis—reinforced with a long-term focus and factor-investing filter.
I recommend the discounted earnings model (DEM) as a great starting point for calculating valuations. It seamlessly combines simplicity and efficiency with effectiveness—producing accurate, reliable, repeatable, and actionable valuations for the average retail investor.
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