The Theory and Practice of Investment Management: Asset Allocation, Valuation, Portfolio Construction, and Strategies, Second Edition

DISCOUNTED CASH FLOW MODELS

If an investor buys a common stock, he or she has bought shares that represent an ownership interest in the corporation. Shares of common stock are a perpetual security—that is, there is no maturity. The investor who owns shares of common stock has the right to receive a certain portion of any cash dividends—but dividends are not a sure thing. Whether or not a corporation pays dividends is up to its board of directors—the representatives of the common shareholders. Typically, we see some pattern in the dividends companies pay: Dividends are either constant or grow at a constant rate.

But there is no guarantee that dividends will be paid in the future. It is reasonable to figure that what an investor pays for a share of stock should reflect what he or she expects to receive from it—a return on the investor’s investment. What an investor receives are cash dividends in the future. How can we relate that return to what a share of common stock is worth? Well, the value of a share of stock should be equal to the present value of all the future cash flows an investor expects to receive from that share.

To value stock, therefore, common stock analysts must project future cash flows, which, in turn, means projecting future dividends. This approach to the valuation of common stock is referred to the discounted cash flow approach. There are various discounted cash flow (DCF) models that we can use to value common stock. We do not describe all of the models. ...