Three Methods to Calculate the Fair Value of a Stock
Calculating the fair value of a stock is an exercise stock investors often practice as a means of determining the actual of “intrinsic” value of a stock to help determine whether any particular stock presents a good investment opportunity. By collecting and analyzing data from company financial statements, including balance sheets, income statements, and cash flow statements, investors can decide whether the market has assigned a fair value to a stock or whether that potential penny stock is currently under or over-priced. While the three fundamental approaches to stock valuation outlined below calculate intrinsic value in different ways, they also seek to assign a value today based on future company performance expectations.
Discounted Cash Flow
Discounted cash flow (DCF) seeks to determine the fair value of a stock today based on future cash flow projections discounted down to a current value. The DCF approach operates under the assumption that the value of a stock is arrived at by assessing its future performance through cash flow projections and discounting those cash flows to account for the time value of money. Many stock investors like the DCF approach to stock valuation because it forces them to think about and analyze the future prospects of a company in order to price a stock today.
Dividend Discount Model
The dividend discount model (DDM), like the DCF model, looks to arrive at stock fair value by discounting future cash flows into current dollar values. Unlike the DCF model though, DDM uses the dividends paid to investors to price the stock. The DDM model can be useful for pricing the stocks of more mature companies as those are the companies that are more likely to pay dividends to shareholders. Like the DCF model, the DDM requires the investor to assign a discount rate to future cash flows (again, dividends in this case) but it also require a projection regarding the dividend growth rate.
Net Current Asset Value per Share
Developed by Benjamin Graham, the net current asset value per share (NCAVPS) analyzes a company’s current assets, total liabilities and the number of shares the company has outstanding to arrive at a fair stock value. Specifically, the NCAVPS calculation subtracts total liabilities from current assets and divides that total by the number of shares outstanding. According to Graham, a financially sound company whose stock price was not more than 67% of the NCAVPS made for a potential investment candidate.