Guest Post: Define the Right Stock Price in a Volatile Market
This is a guest post by Mike, aka The Dividend Guy. He authors The Dividend Guy Blog since 2010 and manages portfolios at Dividend Stocks Rock. He is a passionate investor.
Over the past 5 years, investors have been rewarded by a very strong bullish market. Until recently, the spectre of having a negative year on the stock market wasn’t even a possibility. But as you know, Mr. Market has this habit of changing its mood rapidly. The latest “non-announcement” coming from the FED set the table for what could be a very long autumn on the market.
However, a market correction always brings buying opportunities to our door. The key is to be able to determine the difference between a buying opportunity or simply a stock falling because its business model can’t keep up anymore. This is when a strong investment philosophy comes in handy, especially if you have a method to determine a company’s intrinsic value.
How You Can Use Stock Valuation to Your Advantage
Stock valuation sometimes sounds like black magic to investors. You have to take into consideration several assumptions. The more you add up during your calculations, the more chances you have of not being right and doing the math for nothing.
However, it is possible to use a simple stock valuation method to give you a range of how much this stock is worth for you. The stock valuation method I like best is the dividend discount model. It basically helps investors assign a value to a stock considering its dividend growth ability. In other words, you look at a stock like as if it was a money distribution machine.
In order to use the dividend discount model, you need 3 metrics:
Discount Rate: Roughly said, this is the return you aim for when you make an investment. How much you discount it by can vary. You could, for example, use a “risk-free” rate of return, such as the yield on a U.S. Government Treasury Bill. Or, you could use Weighted Average Cost of Capital (WACC). More appropriately (and simply) in my view, what you should usually use is your targeted rate of return, which would naturally be at a premium to whatever the current risk free rate of return is. In other words, if you hope to make 10% off your investment, just use 10% as your discount rate.
Dividend Paid: This is very easy to obtain as most free financial websites can give it to you. You simply have to use the yearly dividend paid.
Dividend Growth Rate: The dividend growth rate is harder to determine since it has to come from your own assumptions. I usually look at the past 5 and 10 year dividend growth rates to learn more about management dividend policy. Then, I consider the current company situation including its payout ratio and recent revenue and EPS growth trends. If the revenue and EPS growth aren’t there, you can bet that dividend growth will shrink in the upcoming years.
Since 2 out of 3 metrics are coming from your assumptions, it is important to leave room for error. This is when the margin of safety comes into play.
Using a Margin of Safety
The point of having a margin of safety is to target stocks trading under their fair market value according to your calculations. For example, if I value shares of XYZ at $40, a good entry point for me would be below $36 to give me a margin of safety of 10%. If I’m wrong with my calculations, I have a buffer to cover for my assumptions.
The concept of a margin of safety is particularly useful in a highly volatile market. It enables you to trigger your trade at the right moment knowing you are buying the stock under the value you calculated. Keep in mind that fundamentals play a role in the company’s valuation; not the short term volatility of the market.
Dividend Discount Model Spreadsheet for Quick but Efficient Valuations
Between my two investment blogs and my dividend investing platform, I do several stock analyses each week. I had to find a way to streamline my stock valuation methodology. One tool I found is the Dividend Discount Model Spreadsheet that comes in the Dividend Monk’s Dividend Toolkit.
Specifically, it’s a spreadsheet tool that lets you put in a single set of inputs, and then it automatically calculates a range of fair values based on different outcomes. The spreadsheet I use most is the two level dividend growth spreadsheet.
This spreadsheet enables me to use a dividend growth rate for the first ten years and another one afterwards. The first dividend growth rate is used to take into consideration the current company situation. In other words, if you believe the company is set for great growth for the next coming years, you can use a higher dividend growth rate for the first 10 years and use a more reasonable rate over the longer term.
For example, if I think company XYZ will increase its dividend by 8% in the near-term since business is going well but I don’t want to boost the company’s valuation too much, I can use the 8% for the first 10 years and reduce it to 6%. As for the discount rate, I use a range between 9% and 11% depending on the overall company’s risk. I can enter the inputs in the spreadsheet as follow:The Toolkit makes the calculations automatically:As you can see, I have a fair value of $83.46, but the spreadsheet also gives me other possibilities to evaluate my margin of safety rapidly. This is how I know if I’m getting a good deal or not!
If you are interested in learning more about the Dividend Toolkit and its spreadsheet, you can read more about it here.