Intrinsic Valuation Models

Once the required rate of return ( $r$ ) is determined, you can apply intrinsic valuation models to calculate the stock’s fair value.

The Dividend Discount Model (DDM)

The DDM values a stock as the present value of all its future dividend payments:

P_{0} = \sum_{t = 1}^{\infty} \frac{D_{t}}{{(1 + r)}^{t}}

For mature, slow-growing firms with stable payout policies, this simplifies to the Gordon Growth Model (GGM):^gordon1959

P_{0} = \frac{D_{0} (1 + g)}{r - g}

where $D_{0}$ is the most recent dividend and $g$ is the perpetual dividend growth rate (which must be strictly less than $r$ ). DDM is highly sensitive to the growth rate assumption and is useless for non-dividend-paying growth firms.

Discounted Cash Flow (DCF) Model

The DCF model represents the analytical gold standard for corporate valuation. Rather than relying on dividends, it projects the actual cash generated by the business that is available for distribution to all capital providers:

P_{0} = \sum_{t = 1}^{n} \frac{{FCF}_{t}}{{(1 + r)}^{t}} + \frac{TV}{{(1 + r)}^{n}}

where ${FCF}_{t}$ is the projected Free Cash Flow to the Firm (FCFs), and TV is the Terminal Value representing all cash flows beyond the discrete projection period ( $n$ ):

TV = \frac{{FCF}_{n} (1 + g)}{r - g}

The $g < r$ constraint is not optional; if you let $g$ approach $r$ , the denominator goes to zero and the terminal value goes to infinity, which is where most amateur DCF models accidentally find the valuation they wanted. The harder constraint is economic: no firm can grow its cash flows faster than the economy it operates in forever, because eventually it would be the economy. The textbook ceiling for $g$ is long-run nominal GDP growth of the firm’s home market — in the US, roughly 4–5% (about 2% real plus 2–3% inflation). Anything above that is a forecast that the company will, given infinite time, become larger than the country. A useful discipline: run the model with $g$ at three values — 0%, the 10-year Treasury yield, and long-run nominal GDP — and present the range. If the investment only works at the high end of $g$ , you are not buying a business, you are buying an assumption.

To project FCF, construct a detailed three-statement model from the firm’s historical filings on EDGAR:

FCF = EBIT \times (1 - T) + D&A - CapEx - Δ Working Capital

where EBIT is earnings before interest and taxes, $T$ is the corporate tax rate, D&A is depreciation and amortization, CapEx is capital expenditures, and $Δ Working Capital$ is the change in operating working capital. While highly versatile, DCF models are highly sensitive to small adjustments in inputs and should primarily be applied to mature businesses with stable, predictable cash flows (such as regulated utilities or steady consumer franchises), rather than highly volatile biotechnology, cyclical mining, or early-stage venture companies.

Weighted Average Cost of Capital (WACC)

The discount rate $r$ in a firm-level DCF model is the Weighted Average Cost Of Capital (WACC), representing the blended cost of debt and equity financing:

WACC = (\frac{E}{V} \times r_{e}) + (\frac{D}{V} \times r_{d} \times (1 - T))

where $E$ is the market value of equity, $D$ is the market value of debt, $V = E + D$ , $r_{e}$ is the cost of equity (estimated via CAPM), $r_{d}$ is the pre-tax cost of debt (the yield to maturity of the firm’s outstanding bonds), and $T$ is the corporate tax rate. The term $(1 - T)$ captures the corporate tax shield, reflecting that interest payments are tax-deductible.

WACC sets the firm’s capital hurdle. A business only creates economic value if its return on invested capital (ROIC) exceeds its cost of capital:

Economic Value Created = (ROIC - WACC) \times Invested Capital

A company that consistently generates an ROIC below its WACC destroys shareholder value, even if the income statement reports a positive accounting net income.

The Residual Income Model (RIM)

For firms that do not pay dividends or exhibit highly volatile free cash flows, the Residual Income Model (RIM) (or Ohlson Model^ohlson1995) provides a highly robust alternative. RIM shifts the focus from cash flows to economic profit, valuing the stock as the sum of its current book value and the present value of all future expected residual income:

P_{0} = B_{0} + \sum_{t = 1}^{\infty} \frac{{RI}_{t}}{{(1 + r_{e})}^{t}}

where $B_{0}$ is the current book value per share, $r_{e}$ is the cost of equity, and ${RI}_{t}$ is the residual income in year $t$ , defined as the net income exceeding the equity cost of capital:

{RI}_{t} = {Net Income}_{t} - (B_{t - 1} \times r_{e})

Because RIM anchors its valuation to the firm’s current book value (which is immediately recognized on the balance sheet), the model is significantly less sensitive to terminal value assumptions than DCF models, making it highly superior for valuing financial institutions or capital-intensive service firms.

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