Want to know how to value a stock? Here is the stock valuation basics class.
Become your own stock worth calculator for Discounted Cash Flow / Price over Earnings / Dividend Cash Flow
Valuing a publicly traded company is all about figuring out how much it’s worth, what someone might pay to buy it, or what its stock price should be. Think of it like trying to price a house or a car, but with a company, you’re looking at its money-making ability instead of its square footage or horsepower. There are lots of ways to do this, and some are simpler than others. We are going to walk through three methods, starting with the easiest and working up to the toughest: the Price-to-Earnings (P/E) Method, the Dividend Discount Model (DDM), and the Discounted Cash Flow (DCF) Method. These are like different tools you’d pick up depending on how much time and effort you want to put in. I’ll break each one down step by step in plain, everyday language so anyone can follow along. This is a great way to check your favorite stock market personalities’ predictions online to see if you should actually be paying them that $100 a month or not, and also a great way to make a fortune like Warren Buffet has.
Before we start on this journey, lets take a moment to look back:
If you haven’t yet read my Stock Market 101, and are a new trader please read this.
If you haven’t structured as a Roth IRA to reap the great tax benefits, read Never Pay a Tax on Your Profits
Method 1: Price-to-Earnings (P/E) Method – The Easiest Way
This is the simplest way to get a very general value of a company, kind of like checking how much people are paying for a burger based on how tasty it is. It’s quick, uses numbers you can find easily, and gives you a rough idea of whether a stock is a good deal, once you compare it to other businesses in its market segment. The idea here is to see how much investors are shelling out for every dollar of profit the company makes. It even rarely requires math, as it is often readily available on most platforms you look up stocks on.
Step 1: Find the Company’s Earnings
First, you need to know how much money the company is making. This is its profit, often called "net income" or just "earnings." It’s what’s left after the company pays all its bills—like salaries, rent, taxes, and supplies. You can find this number on the company’s financial statements, which they put out every year or every quarter. If that sounds like a hassle, just hop onto a site like Yahoo Finance, Google Finance, or even the company’s own investor page—they usually list it there. For example, let’s say a company made $100 million in profit over the last 12 months.
Step 2: Figure Out Earnings Per Share (EPS)
Next, you take that profit and divide it by the number of shares the company has floating around. Shares are like little pieces of ownership—think of them as slices of a pizza. If the company has 50 million shares, you’d do $100 million ÷ 50 million = $2. That’s $2 of profit for every share, or the Earnings Per Share (EPS). Good news: most financial websites already do this math for you and list the EPS right next to the stock price, so you might not even need a calculator.
Step 3: Look Up the Stock Price
Now, check how much one share of the company costs on the stock market. This is what people are buying and selling it for right now. You can find it anywhere stocks are tracked—apps, websites, even the news. Let’s say the stock price is $40 per share.
Step 4: Calculate the P/E Ratio
Here’s where the magic happens. Divide the stock price by the EPS to get the Price-to-Earnings ratio, or P/E. So, $40 ÷ $2 = 20. This means people are paying $20 for every $1 of profit the company makes. It’s like saying a burger costs $20 because it comes with $1 worth of toppings—it tells you how much “extra” people are willing to pay.
Step 5: Compare It to Other Companies
A P/E of 20 doesn’t tell you much by itself—it’s like knowing a burger costs $20 but not knowing if that’s a steal or a rip-off. You need to compare it to similar companies in the same business. If you’re looking at a tech company, check the P/E of other tech companies. If the average P/E for tech is 25, then 20 might mean this stock is “cheap” (undervalued). If the average is 15, it might be “expensive” (overvalued). You can find industry averages on financial sites or by googling something like “average P/E for [industry name].”
Step 6: Guess a “Fair” Stock Price
If you think the company deserves a P/E more like its competitors, you can figure out what the stock price should be. Say the industry average P/E is 25, and the EPS is $2. Multiply 25 × $2 = $50. That’s your “fair” price—suggesting the stock might climb to $50 from $40 (undervalued) or drop if it’s already higher (overvalued). It’s a quick way to spot a bargain or a dud.
Why It’s Easy and Useful
The P/E method is a breeze because it uses stuff you can find in seconds and doesn’t need much guesswork. It’s like sizing up a deal based on what everyone else is paying for something similar. But it’s not perfect—it only looks at profits right now, not what might happen later, and it ignores things like debt or growth. Still, for a fast check, it’s hard to beat, and can be powerful when combined with listening to recent earnings calls, CEO interviews, and reading SEC filings to help you get an idea of the future.
Method 2: Dividend Discount Model (DDM) – Medium Difficulty
This method is a step up in effort, like figuring out how much a rental property is worth based on the rent it pays you. It’s great for companies that pay dividends—those regular cash payouts to shareholders you get on an intermittent basis (Note: dividend stocks are rarely also growth stocks). The idea is that a stock is worth all the future dividends it’ll give you, adjusted to today’s value. It’s not as simple as P/E, but it’s doable with a little math.
Step 1: Check the Current Dividend
Start with how much the company pays in dividends per share right now. This is like the “rent” you get for owning the stock. Companies announce this when they pay it out—look on their website, financial statements, or stock sites. Say a company pays $1 per share each year.
Step 2: Guess How Much Dividends Will Grow
Next, you need to predict if those dividends will get bigger over time. Some companies raise dividends every year, others don’t. Look at their past—have they bumped it up 5% a year for the last decade? Check their dividend history online (sites like Dividend.com can help). Let’s say you think this company will grow its dividend by 5% annually. So, next year it’s $1 × 1.05 = $1.05, then $1.05 × 1.05 = $1.10, and so on.
Step 3: Pick a Discount Rate
This part’s about figuring out what those future dividends are worth today. Money in the future isn’t as valuable as money now because you could invest today’s money and earn interest. Pick a “discount rate” to shrink those future payouts back to today’s dollars—think of it like an interest rate you’d want to beat. A safe bet is 8-10% for most companies; let’s use 10%. This rate depends on how risky you think the company is—riskier ones might need a higher rate, like 12%.
Step 4: Do the Math with a Formula
Here’s where it gets a bit math-y, but it’s not too bad. If dividends grow forever at a steady rate, you can use a simple formula called the Gordon Growth Model:
Stock Value = Dividend Next Year ÷ (Discount Rate - Growth Rate)
So, next year’s dividend is $1.05 (current $1 × 1.05). Plug it in: $1.05 ÷ (10% - 5%) = $1.05 ÷ 0.05 = $21. That means the stock should be worth $21 per share based on its dividends.
Step 5: Check the Stock Price
Now compare that $21 to the actual stock price. If it’s trading at $18, it might be undervalued—a good buy. If it’s $25, it might be overpriced. This tells you if the market agrees with your dividend-based value.
Step 6: Tweak If Needed
If the growth rate or discount rate feels off, play around with them. What if growth is only 3%? Then it’s $1.03 ÷ (10% - 3%) = $1.03 ÷ 0.07 = $14.71—way lower. This shows how sensitive the result is to your guesses, so double-check your assumptions against the company’s track record or industry trends.
Why It’s Medium Difficulty
The DDM takes more thought than P/E because you’re predicting the future and doing a little math. It shines for stable companies—like utilities or big brands—that pay reliable dividends. But it’s useless for companies that don’t pay dividends (like many tech startups), and it hinges on your growth guess being right. Still, it’s a solid middle-ground method.
Method 3: Discounted Cash Flow (DCF) Method – The Toughest Way
This one’s the heavy hitter, like trying to predict how much a business will earn you over decades and boiling it down to today’s dollars. For dividend stocks, I combine this with the above method to get both the future price of the stock plus the gains from dividends calculated together. It’s the most detailed and flexible, but it takes the most work and guesswork. You’re valuing the company based on all the cash it’ll make in the future, not just profits or dividends.
Step 1: Estimate Future Cash Flows
Start by guessing how much cash the company will bring in over the next few years—usually 5 or 10. This isn’t profit—it’s “free cash flow,” the money left after paying for things like equipment and running the business. Find past free cash flow in the company’s financial statements (look for “cash flow from operations” minus “capital expenditures”). Say it’s $50 million last year. Now guess if it’ll grow—maybe 5% a year based on past trends or industry growth. Year 1: $50 million × 1.05 = $52.5 million; Year 2: $52.5 million × 1.05 = $55.1 million, and so on.
Step 2: Choose a Time Frame
Pick how many years you’ll predict—5 is common because guessing too far gets dicey. After that, you’ll estimate a “terminal value” for all the cash beyond year 5. Let’s stick with 5 years for this example.
Step 3: Discount the Cash Flows
Future cash isn’t worth as much as cash today, so you shrink it back using a discount rate—like 10% again. For Year 1’s $52.5 million: $52.5 million ÷ 1.10 = $47.7 million today. Year 2’s $55.1 million: $55.1 million ÷ (1.10 × 1.10) = $45.5 million. Do this for all 5 years. It’s tedious, but a spreadsheet can help—multiply each year by 1.10 raised to that year’s power (e.g., 1.10^3 for Year 3).
Step 4: Calculate Terminal Value
After 5 years, you don’t stop—you guess what the company’s worth forever after that. A common trick is to assume the last year’s cash flow ($62.1 million in Year 5) grows slowly forever, like 2% (a safe long-term growth rate). Use this formula:
Terminal Value = [Year 5 Cash Flow × (1 + Growth Rate)] ÷ (Discount Rate - Growth Rate)
So, $62.1 million × 1.02 ÷ (10% - 2%) = $63.3 million ÷ 0.08 = $791.8 million. Then discount it back to today: $791.8 million ÷ (1.10^5) = $491.9 million.
Step 5: Add Everything Up
Sum the discounted cash flows from Years 1-5 plus the terminal value. Let’s say Years 1-5 add up to $200 million (after discounting). Total value = $200 million + $491.9 million = $691.9 million. That’s the company’s worth today.
Step 6: Divide by Shares
Take that total and divide by the number of shares outstanding—say 50 million. $691.9 million ÷ 50 million = $13.84 per share. If the stock’s at $10, it might be a steal; if it’s $20, maybe overpriced.
Step 7: Double-Check Your Guesses
This method lives or dies by your predictions. If growth is 3% instead of 5%, or the discount rate jumps to 12%, the value changes a lot. Test different scenarios to see a range—say $10 to $16 per share—and decide what feels realistic based on the company’s past and industry.
Why It’s Tough but Powerful
The DCF is a beast because it needs detailed forecasts and a fair amount of relatively easy math, anyone is capable of this method. You’re betting on guesses about cash, growth, and risk only, everything else is hard numbers. But it’s awesome for companies with big future potential—like tech or startups—since it looks beyond today. It’s just way more work than P/E or DDM. This is my favorite and most used method, it gives you the best outlook for the company once you understand the industry you are looking at. Warren Buffet once said “Never invest in a business you don’t understand.”
Wrapping It Up
These three methods are like different lenses to see a company’s value. The P/E Method is the quick snapshot—great for a fast check using today’s profits. The Dividend Discount Model is the steady paycheck approach—perfect for dividend payers with a little future planning. The Discounted Cash Flow Method is the deep dive—ideal for big-picture thinkers but heavy on effort. Pick the one that fits the company and how much time you’ve got. Together, they give you a solid toolkit to spot a stock that’s worth your money!