A Shortcut For Calculating The Value Of A Stock
Summary
- A simple ratio is all you need to calculate the present value of an income stream.
This shortcut actually applies to any investment with a income stream, discounted to infinity. The typical formula and shortcut are below:
One can use yearly earnings, cash flow, dividends, or other variables, depending on the circumstances. I’ll use earnings, which I often prefer, for the sake of illustration:
It doesn’t get much easier than a simple ratio, does it?
I find the most useful number to use as a discount rate is an investor’s opportunity cost in terms of rate of return. This is the highest rate of return an investor can expect to earn on other investments, adjusted for risk, liquidity, and other factors. This ensures an investor doesn’t overpay for an investment opportunity, given his/her current portfolio. It is an example of subjective value.
Of course, a different discount rate will apply if trying to determine fair value. In this case, one can use the projected average annual income flow rate, average rate for the industry, or weighted cost of capital.
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