A reader asked us to write about valuing equities using the Discounted Cash Flow method sometime back. It has been long overdued...sorry dude or duddette...we have been busy analysing some stuff of late. Before you read on, we would like to mention that this method entails a lot, a lot and we mean a lot of assumptions and it is highly theorectical. Garbage in- garbage out. Why do you think Research Reports target prices are nearly always way off target? Anyway, its the thought process that counts and not the final target price. Who knows, when thinking through the process..you may actually gain insights on the stock you are researching. So its not useless..this model.

There are many forms of DCF analysis and we will be looking at discounting dividends. This is most appropriate for valuing stable companies (for example in a mature industry) and those that have a consistent payout of dividends . (Please note that there are other types such as discounting Operating Free Cash flow or discounting Free Cash flow ).We will be using SingPost as an example. See below for the yearly dividends they give out. We started from year 2005.

Based on the table above, it is logical to assume that they will be giving out at least S$0.0625 in dividends every year from 2009 and beyond. So here comes the DCF formula. Its looks ugly but its actually quite easy. SGDividends will walk you through. Figure 1

The foundation of this formula is that the value of a asset ( stock in this case) is the present value of its expected future cash flows ( dividends in this case). In the above formula, it is taking the present value of all the dividends up to infinity years ahead and bringing it back to the present value, now. People then compare this present value now with the current stock price to see if its cheap or not. The dividends for a company could grow in time, therefore, the variable g takes into account the dividends growth.

As SGDividends is all about making complicated things even easier than easy. We are going to derive a formula which will be easier than easy to use. The derivation is below in figure 2, but you can skip this part amd jump to the final formula in Figure 3.

Figure 2

You can read up on the sum of infinity through thislink. From the above maths in figure 2, we derive the following formula in figure 3 from the equation in figure 1. Isn't it much easier to use now?

Figure 3



So let's put all this mumbo-jumbo in practice, shall we?

For Singpost:

Dividends for current period ( or most recent period) , Do= S$0.0625.

As it is in a mature industry, assuming dividends is growing slowly at a rate, g = 2%.

Let's assume your required rate of return, K = 6% ( We use 6% just to follow the rate from DBS preferential shares. It can be anything you wish because its YOUR required rate of return.)

Value of stock = 0.0625 / ( 0.06 - 0.02) = $1.5625

Price currently as of 21 Nov 2008 as listed on SGX = $0.76.

Don't go rushing to buy this stock yet as we have said before there are many assumptions. Firstly, there is no guarantee that Singpost will continue giving out dividends or dividends will grow. There is no guarantee that Singpost will last forever, it might go bankrupt like Ferrochina ( haha...do you think so?). It is theoretical and you will realise that is not appropriate for all companies, since some companies don't give out dividends.