The two most common methods so far are the discounted cash flow which in short, stands for DCF and the dividend discount model which in short, stands for DDM. So far, I am favouring the DDM over DCF because it appears to be more realistic although it depends on how you use the formulas. The formulas are only as good as the numbers itself, thus if you input garbage into the formula, your answer is likely to be as good as your input. The formula for DDM is given as below.
In other words, the value of the stock is the present value of the sum of all the dividends that you are going to receive in the future til perpetuity. However, this seems to be not very realistic. That is because, I don't buy a stock simply for the the dividends itself. The reason I buy a stock is due to the potential for capital gains due to price appreciation and dividends. Thus, I will sell the stock when it appears to be overvalued and this is often the time when I can lock in on my potential gains. In other words, the value of a stock to me is the present value of all the dividends that I am going to receive plus the selling price of the stock in the future. Thus I should discount the dividend individually and the selling price of the stock back to its present value.
For example, let's use the STI ETF as an example. For a start, I will need to find the dividend and the expected selling price of the STI ETF in the future. Currently, the STI ETF distributes a dividend of $0.10 per share. Let's make a conservative assumption that this dividend will be the same for the next 5 years.
For the selling price in the future, I am expecting to sell the STI ETF in 5 years time at a price of $4.50. This is because going by past instances, the average time for the STI to recover from its bottom is 2.6 years and the longest instance was around 5 years. Furthermore, the previous 3 peaks of the STI occurs at 3875.77, 2582.94 and 2137.99 so a target of 4500 in 5 years time should be quite conservative. Lastly, a discount rate of 10% is chosen to be used with the formula or you can see it as the required rate of return that you want from buying the STI ETF is 10%. Thus we will discount the dividend for each of the year for 5 years and the selling price of the STI ETF at the end of five years. The computation is given below.
Thus the value of the STI ETF is at $3.17. Since the current price is around $1.75, this means that it is at a significant discount to the value that will give you a rate of return of 10%. This would mean that the STI ETF would be a good buy at its current price. This computation can also be applied to other stocks too.
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Thanks very much for the post. Useful tip on evaluating a good buy.
ReplyDeleteHi,
ReplyDeleteI'm glad that you found this post to be useful.
Kay