What Discount Rate to Use to Determine the Present Value of a Stock?

With the popularity of the Dividend Toolkit, I often get questions by email regarding what is a “fair” discount rate to use to calculate the present value of a stock.

First, I must warn you that stock valuation is sitting on the line separating science and magic: there is a big part of work that involves the rationale & justification of the usage of a specific discount rate, but there is also the magic of events happening on the stock market putting our decision to the test. I guess the most important part is to understand the effect of the discount rate in our calculation and to clearly establish what discount rate to use to calculate the fair value of a stock. If our methodology is consistent from one calculation to another, our overall investment process will make sense and we won’t be making too many mistakes.

The Idea behind Discounting

This brings up the purpose of discounting. The discount rate is used to calculate how much the money you will receive tomorrow is worth today. In other words: how much should you pay today for an asset that will pay you back later.

You have to discount the future money by an appropriate value in order to translate it into today’s value. 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. This spares you from making a series of calculations and gets straight to the point.

If you want to get, say, a 10% rate of return on your money, then you should use a discount rate of 10% per year when translating future dollars into present dollars. You may also alter it depending on your estimation of the level of risk involved. For a higher risk investment I’d use a higher discount rate (perhaps 12% or so), while in the case of a very defensive and reliable business I may use a discount rate of 8%. It could also be tied to the current risk free rate of return, such as being equal to the current U.S. Treasury Bill return + 8% or so.

So how much is \$10 a year from now, worth to you today, if you seek a 10% rate of return on your money? The answer is \$9.09. If you had \$9.09 right now, and you could invest that money at an annual rate of 10%, then you could turn that \$9.09 into \$10 in one year, since \$9.09 multiplied by 1.1 equals \$10. So \$10 one year from now is only worth \$9.09 to you today. In this scenario, \$10 in a year, or \$9.09 today, are equivalent.

It was calculated via this equation:

DPV = FV / (1 + r)

here DPV means “discounted present value”, and FV means “future value”, and r is your discount rate (which in this case is 10% or 0.1). The \$10 is future value, and you want to know the discounted present value of that ten dollars, so you divide the FV by (1 + 0.1) to get the DPV of that money.

If you wanted to know what \$10 that you’ll get in two years is worth today, you make a minor adjustment to that equation, and use DPV = FV / (1 + r)^2, since the discount rate must be applied for two years. The answer is that receiving \$10 two years from now is worth \$8.26 to you today, since you can take \$8.26 and multiply it by 1.1, and then multiply it by 1.1 again, to get \$10. In this scenario, \$10 in two years, or \$8.26 today, are equivalent.

So we see that DPV = FV / (1 + r)^n, for a given future value, where n is years. If we have a series of future cash flows each year, then the equation is this:

DPV = (FV1)/(1+r) + (FV2)/(1+r)^2 + … + (FVn)/(1+r)^n

If you find this part complicated, don’t worry, the Dividend Toolkit includes excel spreadsheets doing the calculations for you. You simply have to plugin the numbers.

Different Stock, Different Discount Rate

As previously mentioned, I customize the discount rate in my calculation according to the company I analyze. I think it makes more sense that way as I would expect a higher rate of return from a company showing more risk and vice-versa. This is at the foundation of any stock valuation process as every investor wants to be rewarded for the risk taken.

The discount rates I use vary between 9% and 12%. A company with stellar numbers that will stabilize my portfolio such as 3M Co (MMM) will be discounted at 9% while a company evolving in a highly volatile environment such as Helmerich & Payne (a drilling company in the oil industry) will require a higher return on my investment and will be discounted at 12%.

The use of a low discount rate (9-10%) obviously leads to more undervalued stocks according to your calculation. This is why it is important to be very cautious about the reasons you discount with such low rate. I’ve read other bloggers going under 9% based on the fact that the current risk-free rate is almost zero and the premium shouldn’t be that high. Unfortunately, while such rationale seems to make sense at first glance, this puts almost all dividend growth stocks in an undervalued position. We all know this isn’t possible.

There are no rules preventing you comparing multiple discount rates for a single stock valuation process. Using different rates will help you assess the direct impact of a 1% change and will expose the right margin of safety. The margin of safety is some kind of buffer between what the stock will really be worth in a year from now and how much you calculated its value at. If you can benefit from a 10-20% margin of safety, you have a very good chance of making a good investment.

Example of Discount Rate Use for Present Value of a Stock

In order to help you understand, I will make a dividend discount model (DDM) calculation example with Johnson & Johnson (JNJ) since everybody knows this company.

Since the company is a well-established dividend aristocrat, I don’t expect JNJ to double its value in the near future. The company is well diversified with a world class brand portfolio and sells in just about every country across the planet. For these reasons, the discount rate used is 9%. I also like to use a double stage DDM to see the impact of a first growth rate for the first 10 years and another for the years after.

I use a DDM with a 7.5% dividend growth rate (matching the past 5 years) for the first 10 years and reduce it to 6% afterwards:

Source: Dividend Toolkit

The company is currently trading at close to a 20% discount according to my calculation. As you can see, the stock price is completely different if I use a 10% discount rate. In fact, there is a gap of roughly 25% between the fair value with a 9% rate and a 10% rate. A one percent spread makes difference between an undervalued stock by 20% and an overvalued stock by 10%.

This is a good example to show you that the calculation is useful, but can’t be the only reason why you buy or sell a stock. The use of the right discount rate included in a complete stock analysis process will make sense as you will validate your investment thesis with such calculations. This is how you will end-up with a sound investment decision.

Disclaimer: I own shares of JNJ and HP

Summary:

Coca-Cola is the world’s largest beverage manufacturer. Its leader position makes it one of the most beautiful money making machines on the market.

KO’s distribution network is one of its most powerful competitive advantages. It can introduce any type of beverage across the world in a heartbeat.

However, currency headwinds coupled with an increasing taste for healthy products has slowed down Coca-Cola’s revenue growth potential.

DSR Quick Stats

Sector: Consumer defensive

5 Year Revenue Growth: 8.22%

5 Year EPS Growth: 4.44%

5 Year Dividend Growth: 8.27%

Current Dividend Yield: 3.08%

What Makes Coca-Cola (KO) a Good Business?

There is little to say that hasn’t been said already about Coca-Cola so I’ll make this section brief.

First things first, Coca-Cola is probably the best known brand across the globe. Such brand power cannot be replicated. Besides the classic Coke, the company owns several popular brands such as Vitamin Water, Powerade, Minute Maid, Dasani, Simply Orange and most recently Keurig. It claims to own twenty brands worth over \$1 billion each in its portfolio.

KO’s second notable competitive advantage is its distribution power. The company has the ability to offer its products in over 200 countries. Here’s an idea of how wide this company is spread:

Source: Coca-Cola infographic

Therefore, each time the company has a new product; it can promote and distribute it across the world the next morning.

Ratios

Price to Earnings: 24.49
Price to Free Cash Flow: 20.75
Price to Book: 6.424
Return on Equity: 24.34%

Revenue

Revenue Graph from Ycharts

Coca-Cola is experiencing a small decline in North America for its popular carbohydrate drinks. A strong currency doesn’t help to support revenue growth either. We can say that revenue is relatively flat since 2012. Looking forward, I don’t expect an important increase in 2016, but the US dollar should not be a major factor since most of its strength has already been taken into account.

How KO fares vs My 7 Principles of Investing

We all have our methods for analyzing a company. Over the years of trading, I’ve been through several stock research methodologies from various sources. This is how I came up with my 7 investing principles of dividend investing. The first four principles are directly linked to company metrics. Let’s take a closer look at them.

Source: Ycharts

Principle #1: High dividend yield doesnt equal high returns

I always remain cautious about companies paying over 5% dividend yield. They always show greater risks than lower yielding stocks.

Source: data from Ycharts.

Coca-Cola’s dividend yield is becoming quite interesting lately going over the 3% bar. As you can see, the dividend paid keeps increasing year after year and the yield is staying within relatively the same range. This means the stock gains in value at the same pace.

Principle#2: If there is one metric, its called dividend growth

As a member of the selective dividend aristocrats group, KO’s dividend growth reputation is well defined. Over the past 5 years, its dividend growth rate is around 8%, doubling its dividend payment every 9 years or so.

The fact the company is selling consumable products across the world makes KO one of the most efficient cash flow machines in the stock market. A part of this cash flow is always redistributed to its shareholders.

Principle #3: A dividend payment today is good, a dividend guaranteed for the next ten years is better

We know that KO is a shareholder friendly stock, but is it able to keep increasing its dividend payment as it has in the past? I like to cross the dividends paid along with the payout ratio to find my answer:

Source: data from Ycharts.

While sales in units is increasing, currency headwinds has greatly affected the company’s earnings. This is why the payout ratio keeps increasing as you can see on the chart. While a 90% payout ratio is not amazing, the currency effect should be less important in 2016 and help to stabilize this ratio.

Principle #4: The Foundation of a dividend growth stock lies in its business model

Even though the company is going through a tougher period in terms of growth, it doesn’t take anything away its beautiful business model. KO shows a strong cash flow generation ability and benefits from important economies of scale across its network.

Its economic moat is well protected and we shouldn’t expect KO to be threatened any time soon.

What Coca-Cola Does With its Cash?

KO has been increasing its dividend payment for 53 consecutive years already. This makes it a senior dividend aristocrat. On top of paying its shareholders, the company has an important share buyback program.

In order to support growth and to diversify its product offering, the company doesn’t hesitate to make acquisitions. Its important cash flow is quite useful when it’s the time to buy other brands.

Investment Thesis

As a dividend growth investor, KO should be part of your portfolio. Its cash flow generation ability is quite impressive and it is safe to claim that your dividend payments will double every 7-9 years.

Coca-Cola has the ability to buy other popular brands and introduce them through their network. This will be a great growth opportunity for the years to come. Another growth factor will come from emerging markets. While we have heard about emerging markets potential for over a decade now, the product consumed per capita remains relatively low compared to North America. You can guess that Coca-Cola will benefit from any improvement of the middle class situation in those countries.

Risks

Coca-Cola’s main challenge in my opinion is to generate higher sales from its healthier products. While the company owns several great brands, the carbohydrate drinks sales are still the spine of the company. Long term growth may slow in the future and hurt the dividend growth perspective at the same time.

However, this won’t prevent the company from increasing its dividend. It will just slow down this amazing cash flow machine.

Should You Buy KO at this Value?

If you believe that KO shows a weaker financial forecast than usual, this may be the time to buy it. However, when I look at the past 10 years PE ratio, it seems the market is ready to be patient by valuing the stock relatively high:

Source: data from Ycharts.

A more precise approach is by using the dividend discount model. I will use an 8% dividend growth rate for the first 10 years and reduce it to 7% afterwards. Since we are talking about a strong company, I will use a 10% discount rate:

It looks like the company trades at almost a 20% discount. This partially explains why the market is ready to pay 24 times the earnings.

Final Thoughts on KO – Buy, Hold or Sell?

I think that if you don’t own KO in your dividend growth portfolio, the current valuation should be enough for you to make a purchase. While we are not in a perfect environment, this company will continue to increase its cash flow and distribute higher payouts to its shareholders.

Disclaimer: I hold KO in my DividendStocksRock portfolios.

3 Dividend Growth Stocks with Wide Margins of Safety

The recent drop in the stock market is opening doors to many opportunities. While some investors have felt the heat and decided to abandon ship, others may just find a perfect entry point to make new purchases.

In such volatile markets, wise use of a margin of safety becomes one of your best tools to make the right investing decision. Remember that during a correction, not all stocks are trading at discounts – some of them are simply bad investments and won’t recover.

The difference between catching a falling knife and buying a strong but undervalued company with a margin of safety is a thin line. The whole process behind analyzing a company is crucial and this is where valuation comes into play.

What is a Margin of Safety?

Before using the margin of safety, an investor must be able to evaluate the shares he is looking at. The goal is always to buy undervalued companies if you are looking to make strong profit. A good way to determine the value of a share is to use a dividend discount model. It is a relatively simple model and it’s easy to use. It will help you put a dollar value on a company and its ability to generate dividend payments.

The margin of safety happens once you have determined a value for a company XYZ. Let’s assumed you have made your calculations and you found that company XYZ’s shares should trade at \$10. This is known as its “intrinsic value”. The “\$10” is found based on your stock analysis and dividend discount model. Then, if the company stock is currently trading at \$9, you benefit from a 10% discount; this is your margin of safety. In other words, while you think the company should be worth \$10 a share, you can be wrong in your calculation up to \$1 difference since the company is currently trading lower.

Warning, a wide margin of safety could mean two things:

#1 You found a great buying opportunity

#2 Your calculations are completely off and you missed something about the company’s situation or business model.

In order to show you real life examples, I’ve selected three interesting buys with wide margins of safety:

BlackRock (BLK)

It’s a bad month for the market, and it also affected greatly BLK’s stock price. The concerns come from a general doubt around the industry of investment firms. Typically, this sector is making the bulk of their revenue from fees charged on the assets they manage (called assets under management – AUM). If the market drops, AUM will follow accordingly and fees charged will naturally decline. In addition to this situation, investors have the awful reflex to withdraw part of their money from the market when it drops. This pushes the AUM even lower. However, this recent drop in price is more likely to be a great entry point to buy this leader in the ETF industry. BLK’s leadership position as the largest investment firm combined with its ability to generate higher profitability than its peers makes it a great company to buy. The company is currently trading with a 20% margin of safety:

Caterpillar (CAT)

Among my three examples, CAT is probably the one that is closest to a falling knife and where the margin of safety could be a lure. I personally believe in the company’s leadership position in its sector. While the company could benefit from the solid construction industry in the US, this is about the only good news for the upcoming months.

Caterpillar announced another 10,000 layoff round after cutting 20,000 jobs back in 2009. The problem is that the mining industry is dropping like rock ;-). Nonetheless, now that the company is trading at a PE ratio under 11 and showing a dividend yield close to 5%, it could be a very interesting addition to your portfolio.

3M Co (MMM)

MMM is a great example of a good company with a falling stock price that is following the overall market without any good reason. The stock price has followed exactly the same foot steps as the S&P 500 since August.

However, the company shows a stellar balance sheet, awesome product and geographical diversification and a strong ability to increase its dividend payment in the upcoming year. If you pick it up now at a yield of nearly 3%, you will just make a steal off the market.

MMM has recently dropped to a 20% margin of safety. You can rarely pick shares of MMM at a 3% dividend yield.

How To Calculate your Margin of Safety

As you can see, I use a 15 cell discount model matrix. The Dividend Discount Model I use comes with a two stage dividend growth rate. A first one is used for the first 10 years and you have the option to change it for the years after. Then, the calculations are made for you automatically and generates 15 possible values for the same stock price analysis.

This helps you to put into perspective the effect of different discount rates and dividend growth rates used in your calculations. The spreadsheet is offered in my Dividend Toolkit package (you can read more about it here):