Stock Evaluation Methods Paper Example

Introduction

Every company is unique in composition and operation. Different valuation methods are used to analyze the financial performance of the stock markets. Heavyweights like Alibaba are immensely complex with different lines of products like mobile services, banking, software, e-learning, selling of merchandise and many more. Whichever the method used to perform a valuation, the outcome should be good enough and accurate for decision making among the financial analysts and investors. For most blue chip companies, they pay dividends to their shareholders. Dividend Discount Model (DDM) will best suit them for valuation. Other companies don't pay out dividends, reflecting an irregular dividend pattern. Such are best evaluated using Discounted Cash Flow Model (DCF) for the model is used for valuation of dividend-based companies and those which don't pay (Enever, Isaac and Daley 2014, p.50).

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Dividend Discount Model (DDM)

The model uses the net present value (NPV) of future dividends to value a company (Lazzati and Menichini, 2015, p.18). When the future dividend payments are made, they constitute the discounted sum of the worth of the stock. Examples of companies using this model include Coca-Cola, McDonald's, and Procter & Gamble. The DDM model is the stock's intrinsic value given by the summation of the PV of dividends + PV of stock sale price. For companies which don't pay dividends, the cash flow of the stock will serve as the sale price. The model takes different forms depending on the nature of dividend allocation. They all have a similar concept of application:

Let's say a company has a stock paying $40 dividends (div1) this coming year and $43.6 for the other year. You intend to purchase the stock and sell it for $666.6. The intrinsic value of this stock that can return 20% is calculated as:

Present Value (year 1) = $40/ (1.21)

Present Value (year 2) = $40/ (1.22)

Year 1 dividend present value = $33.3, year 2 = $27.8

The PV of the future selling price after the second year = $666.6/ (1.22)

Summation of the PV of selling price and the present value of dividends:

= $33.3 + $27.8 + $462.9; = $524

We have zero growth, constant growth, and variable growth models. For zero growth DDM, the dividend value paid by the stock is the same all through. Constant growth DDM has the dividends growing at a constant rate whereas the variable growth bears two or three phases of growth.

Zero-growth DDM:

Stock's intrinsic value = yearly dividends/ required return rate. If in a stock the dividends paid out are $2.5 per annum, and the required return rate be 5%, intrinsic value = $2.5/ 0.05; = $50.

Constant growth rate DDM:

Stock value = Do(1+g)(Ke-g) = D1(Ke-g) where Do is the year 1 received dividend and D1 is for this year. Ke is the discount rate and g dividend growth rate.

A stock making a payment of $5 this year, with a return rate of 10% and annual growth of 6% will have an intrinsic value of $5.3 (0.1-0.06; = $132.5

Price-to-Earnings (P/E ratio) Multiple Method

This is a pretty simple way of valuing a stock. The metric is used to evaluate the attractiveness of a company's price of the stock (Damodaran, 2016, p.159). It is key to also note that the P/E ratio is not self-sustaining. Other tools must be used to evaluate the real worth of a company. P/E ratio = price per share earnings per share. for example, if earnings per share is $3 and the stock sells the shares at $30, p/e ratio = $30/ $3; = $10. Different industries have different levels of the p/e ratio e.g. the textile industry has a lower ratio than a technological firm.

Discounted Cash Flow (DCF) Model

This method employs the concept of the time value of money. It uses forecasts of the amount of money the company is going to make to calculate the PV. The future value of cash flow is discounted back wars to obtain the present value estimate. To settle on the company by using this analytical method, the value arrived at through the analysis of discounted cash must be higher than the current worth of investment. It can get complex when all the factors that affect the future value of the current have to be considered. These include debt and the cost of equity, forecasted revenue growth, profit margins and the rate of discount.

There are seven steps involved in calculating the DCF analysis: the first step is projections of financial statements. A period of reference of say 5years is settled on depending on operation stage of a company. Small companies have very high growth rates as compared to the giants and stand the highest chance of being liquidated. Balance sheets, cash flow statements are projected to estimate a few networking capitals and capital expenditure within the period of forecasting (Ardalan 2017, p.700). Second is the calculation of the free cash flow to a firm. Third, is the determination of the discount rate using the weighted average cost of capital concept. Calculating the terminal value and present value calculations.

Royal Dutch Shell stock

Introduction

The Royal Dutch Shell company known as Shell is a multinational company dealing with energy and petrochemicals in the whole world. It is a Dutch company headquartered in The Hague, Netherlands and its net worth is around $305 billion. The segments through which it operates are Upstream, downstream, Integrated Gas and Corporate. The Integrated Gas section handles all activities to do with liquefied natural gas (LNG) and its conversion to other products and liquid fuels. Exploration and extraction of natural gas and crude oil are overseen by the upstream segment. After extracting the petroleum raw material, various products are produced and supplied to all the world through the downstream segment. Holdings, treasury, stock, and insurance together with central management functions are run by the corporate segment. For this company, a recommendation for the investors is a strong buy. Though the oil prices have not performed well in the past one year, for Shell PLC, it will be profitable to invest in the stock market. The rationale for settling on this is the adequate size of the sales, a good P/E ratio, a satisfactory P/book ratio, amount of shares outstanding, dividends paid, market capitalization, the cash flow per share and many other metrics of evaluation.

Discussion

When sales of the company are considered for stock investment, they must be adequately big for security reasons. The United States Securities and Exchange Commission establishes the limit to be $340million. Trailing the company for a 12-month period of sales, Shell passes this test far highly. Market capitalization has to be sufficiently large for investment considerations. Multinationals like Shell operate in very diverse economic environments in different countries. Taxation, expenses, and creditors have to be leveraged using the revenues realized. A market capitalization of $1billion is enough for an international company. Shell has it at $251,446 million, performing far higher than the threshold of reference.

Considering the past three fiscal years of Shell, the Price/Earnings ratio has not exceeded 15. Currently, the value is at 10.64, making the company also pass in this category of consideration. Whereas it is tempting for an investor to opt for a company with a very big P/E ratio, but the danger of the big ratio is instability. Small companies and start-ups often times reflect big ratios as compared to the giants who have stayed in the industry. The more you succeed, the higher you go on the ladder, and when you reach the top rungs, it becomes increasingly hard to go higher. The desirable aspect for the Shell P/E ratio is the reliable stability the investors will enjoy with their stock. The Price/Book ratio is reasonably good at 1.25. A prospective company, an investor, would like to settle on should have a very low P/Sales ratio ranging between 0.4 and 0.9 if the company is cyclical in its operation. Shell performs well again in this area, with a 12-month track record falling between the desired range with a value of 0.88 currently. For non-cyclical companies, the P/Sales is allowed to be between 0.75 and 1.50

Free cash per share criterion is met by Shell, going at 0.95. Cash flow in a company is expected to be big enough to sustain company losses for at least three years. When the cash flow per share is high it implies that's a company has value-oriented programs which will be loved by investors. From stock analysts, they suggest that cash flow per share be more than the market's mean cash flow per share of $2.09. The criteria are met by Shell that has cash flow per share of $10.71

Another metric of analysis is the number of shares outstanding. Good companies for investment should have an accumulation of outstanding shares of more than 611million shares. The benefit accrued with having a high amount of outstanding shares is being prominent and legendary, enabling the company to trade higher. Shell company has a total of 1.87billion shares outstanding. The dividend yield of the company is at 6.27%, one of the highest figures around in the market leaders. The potential investor will be pleased to note this because, in business, it is all about making profits. In addition to the stability enjoyed by the Shell PLC in the harsh and competitive industry of oil, investors have all the reason to entrust their wealth into the stock market of the company. There is a minimal chance of things going south from the statics considered herein.

Shell PLC Evaluation using DDM. As highlighted before, it uses the net present value (NPV) of future dividends to value a company. When the future dividend payments are made, they constitute the discounted sum of the worth of the stock. Dividends are used for evaluation because they are pretty simple and straightforward portion that finds its way directly to the investor. The history of dividends proves useful in this area. We will need to calculate the intrinsic value of stock, the dividend growth and the required rate of return...