🎯 Stock Valuation: Finding the TRUE Price of a Stock
Imagine you’re at a candy store, and someone wants to sell you a magical candy jar. They say it costs $100. But how do you know if that’s a fair price? What if the jar is actually worth $200? Or only $20?
That’s exactly what stock valuation is about—figuring out the REAL value of a company’s stock!
🍬 The Candy Jar Story
Let’s say you have a magical candy jar that gives you 1 piece of candy every day, forever. How much would you pay for it?
- If candy costs $1 each, you get $1 every day
- That’s $365 per year!
- Would you pay $100 for something that gives you $365 every year? ABSOLUTELY!
- Would you pay $10,000? Hmm… maybe not so fast!
This is EXACTLY how we value stocks. Stocks are like candy jars—they can give you money (called dividends) regularly. We just need to figure out how much that’s worth TODAY.
📊 What is Stock Valuation?
Stock valuation is like being a treasure detective. You’re trying to find out:
“What is this company REALLY worth?”
The stock market tells you a PRICE (what people are paying right now). But that’s not always the VALUE (what it’s actually worth).
graph TD A["Stock Price"] --> B{Is Price = Value?} B -->|Price < Value| C["🎉 Good Deal!<br/>BUY"] B -->|Price > Value| D["⚠️ Too Expensive!<br/>WAIT"] B -->|Price = Value| E["😐 Fair Price"]
🎯 Simple Example
| What You See | What It Means |
|---|---|
| Stock Price: $50 | What people pay TODAY |
| Intrinsic Value: $80 | What it’s REALLY worth |
| Result | $30 discount! Great buy! |
💰 The Dividend Discount Model (DDM)
The Birthday Money Analogy
Imagine your grandma promises to give you $10 every birthday, forever! How much is that promise worth today?
Here’s the trick: Money today is worth MORE than money tomorrow.
Why? Because you can DO things with money today:
- Buy ice cream NOW 🍦
- Put it in a piggy bank and earn more
- Trade it for toys TODAY
So $10 next year isn’t quite worth $10 today. It’s worth a little less—maybe $9.
The DDM Formula
The Dividend Discount Model says:
Stock Value = Future Dividends, converted to today’s dollars
Stock Value = D₁ / (r - g)
Where:
D₁ = Next year's dividend
r = Required return (what you expect to earn)
g = Growth rate (how fast dividends grow)
🎯 Real Example
Company ABC:
- Pays $2 dividend per share
- You want 10% return per year
- Dividends grow 3% per year
Calculation:
Value = $2 / (0.10 - 0.03)
Value = $2 / 0.07
Value = $28.57
If the stock trades at $25, it’s a bargain! 🎉 If the stock trades at $40, it’s too expensive! ⚠️
🌱 The Gordon Growth Model
The Magic Bean Story
Remember Jack and the Beanstalk? Imagine you have a magic bean that:
- Gives you 1 gold coin this year
- Grows 5% bigger every year
- Keeps growing FOREVER
How much would you pay for this bean?
The Gordon Growth Model is EXACTLY the answer to this question! It’s a special version of DDM that assumes dividends grow at a constant rate forever.
graph TD A["Year 1: $1.00"] --> B["Year 2: $1.05"] B --> C["Year 3: $1.10"] C --> D["Year 4: $1.16"] D --> E["Forever Growing..."] style A fill:#90EE90 style E fill:#FFD700
The Formula (Same as DDM!)
P₀ = D₁ / (r - g)
P₀ = Stock price today
D₁ = Dividend expected next year
r = Your required rate of return
g = Constant growth rate
🎯 Real Example
Coffee Shop Company:
- Just paid $3 dividend
- Dividends grow 4% yearly forever
- You want 12% return
Step 1: Find next year’s dividend
D₁ = $3 × 1.04 = $3.12
Step 2: Calculate value
P₀ = $3.12 / (0.12 - 0.04)
P₀ = $3.12 / 0.08
P₀ = $39
The stock is worth $39 to you!
⚠️ Important Rule
g must ALWAYS be less than r!
Why? If a company grows faster than your required return forever, it would be worth INFINITY dollars! That’s impossible.
| Scenario | Result |
|---|---|
| r = 10%, g = 5% | ✅ Works! |
| r = 8%, g = 3% | ✅ Works! |
| r = 10%, g = 12% | ❌ Doesn’t work! |
💎 Intrinsic Value: The Hidden Treasure
The Lemonade Stand Story
You want to buy your friend’s lemonade stand. They say it’s worth $1,000. But is it?
Intrinsic value is what something is TRULY worth, based on:
- How much money it makes
- How much it will grow
- How risky it is
It’s like finding the hidden treasure inside a box, not just looking at how shiny the box is!
graph TD A["🏪 Lemonade Stand"] --> B["Makes $200/year"] B --> C["Will grow 5%/year"] C --> D["Pretty safe business"] D --> E["💎 Intrinsic Value: $800"]
Market Price vs. Intrinsic Value
| Term | What It Means | Example |
|---|---|---|
| Market Price | What people PAY | $100 |
| Intrinsic Value | What it’s WORTH | $150 |
| Difference | Your opportunity! | $50 profit potential! |
🎯 Real Example
Tech Company XYZ:
You calculate using DDM:
- Annual dividend: $5
- Growth rate: 6%
- Your required return: 11%
Intrinsic Value = $5 / (0.11 - 0.06)
Intrinsic Value = $5 / 0.05
Intrinsic Value = $100
Current market price: $75
The stock is $25 BELOW its intrinsic value! This could be a great investment! 🎯
🛡️ Margin of Safety: Your Safety Net
The Trampoline Story
Imagine you’re learning to walk on a tightrope. Would you practice:
- A) 100 feet in the air with no net? 😰
- B) 3 feet high with a big, soft trampoline below? 😊
Obviously B! The trampoline is your margin of safety.
In investing, the margin of safety is the cushion between what you pay and what you think it’s worth.
Why Do We Need It?
Because we might be WRONG!
- Maybe the company won’t grow as fast
- Maybe there’s a surprise problem
- Maybe our math isn’t perfect
The margin of safety protects us from mistakes!
graph TD A["Intrinsic Value: $100"] --> B["Margin of Safety: 25%"] B --> C["Buy Price: $75 or less"] C --> D["✅ Protected if wrong!"] style D fill:#90EE90
The Formula
Buy Price = Intrinsic Value × (1 - Margin of Safety %)
Example:
Intrinsic Value = $100
Margin of Safety = 30%
Buy Price = $100 × (1 - 0.30) = $70
🎯 Real Example
You calculated intrinsic value: $50
| Margin of Safety | Maximum Buy Price | Protection Level |
|---|---|---|
| 10% | $45 | Low |
| 25% | $37.50 | Medium |
| 40% | $30 | High |
| 50% | $25 | Very High |
Famous investor Warren Buffett aims for at least 25-30% margin of safety!
When to Use Higher Margins
| Situation | Recommended Margin |
|---|---|
| Stable, old company | 15-20% |
| Normal company | 25-30% |
| New or risky company | 40-50% |
| Very uncertain | 50%+ |
🎓 Putting It All Together
Let’s value a real stock step-by-step!
📝 Example: Sunshine Snacks Inc.
Given Information:
- Current dividend: $2.00 per share
- Dividend grows 4% per year
- You want 10% return
- Current stock price: $28
Step 1: Calculate Next Year’s Dividend
D₁ = $2.00 × 1.04 = $2.08
Step 2: Apply Gordon Growth Model
Intrinsic Value = $2.08 / (0.10 - 0.04)
Intrinsic Value = $2.08 / 0.06
Intrinsic Value = $34.67
Step 3: Compare to Market Price
Intrinsic Value: $34.67
Market Price: $28.00
Difference: $6.67 (19% below value!)
Step 4: Apply Margin of Safety (25%)
Target Buy Price = $34.67 × 0.75 = $26
Step 5: Make Decision
Market Price ($28) > Target ($26)
Close but not quite there yet!
Wait for a small dip.
🌟 Key Takeaways
| Concept | One-Line Summary |
|---|---|
| Stock Valuation | Finding what a stock is REALLY worth |
| DDM | Value = Future dividends in today’s dollars |
| Gordon Growth | Special DDM for constant-growth stocks |
| Intrinsic Value | The TRUE worth (not market price) |
| Margin of Safety | Buy below value to protect from mistakes |
🎯 The Golden Rules
- Never pay more than something is worth
- Future money is worth less than today’s money
- Growth matters, but only reasonable growth
- Always leave room for error (margin of safety)
- Price is what you pay; value is what you get!
Remember: Stock valuation isn’t about being perfect—it’s about being approximately right rather than precisely wrong! 🎯